Lower Earnings Response Coefficients Research Articles

Filling in the GAAPs in Individual Analysts’ Street Earnings Forecasts

Analysts’ street earnings forecasts are sometimes based on GAAP earnings and sometimes based on non-GAAP earnings, which exclude various GAAP earnings components. Therefore, differences in analysts’ street earnings forecasts may capture differences in not only expected performance but also the earnings metric forecasted. We argue that analysts who forecast non-GAAP, rather than GAAP, street earnings are more likely to separately analyze earnings components. Consistent with this argument, we find that analysts who forecast non-GAAP street earnings issue relatively more accurate forecasts. We also argue that excluded earnings components often reflect negative transitory items, and that variation across analysts in the earnings metric forecasted suggests that the negative excluded items are forecasted by only a subset of analysts. Consistent with this assertion, we find that variation across analysts in the earnings metric forecasted is associated with a lower consensus GAAP earnings surprise and lower stock returns around the earnings announcement. Finally, although variation in the earnings metric forecasted is a source of analyst forecast dispersion, we find that it is also incrementally associated with a lower earnings response coefficient, consistent with the existence of transitory items. We therefore find that the variation in the earnings metric forecasted is an important source of analyst forecast dispersion that predicts not only a lower earnings surprise but also a lower earnings response. This paper was accepted by Brian Bushee, accounting. Funding: Financial support from the Gatton College of Business & Economics, the KPMG Fellowship at the Mendoza College of Business, and the Goizueta Business School is gratefully acknowledged. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2022.4553 .

Attention to dividends, inattention to earnings?

We examine whether dividends serve as substitutes or complements to accounting information in firm valuation. Consistent with dividends substituting for earnings information, we find that dividend paying firms have 11%–15% lower earnings response coefficients (ERCs) than non-payers. We find more substitution when the dividend provides a stronger signal of permanent earnings: when the firm is less likely to cut the dividend, when the firm is likely to fund the dividend out of earnings rather than cash reserves, or when the dividend is larger. We then show that dividend payers have lower absolute returns, less trading volume, and fewer analyst forecasts at the earnings announcement (EA), suggesting that dividend payers attract less attention to their less informative EAs. Finally, we show that the lower EA attention translates into less earnings management and fewer earnings-related disclosures for dividend payers relative to non-payers. Collectively, this evidence suggests that dividends supply information about permanent earnings and, although costly, could be an efficient way for some firms to satisfy investors’ demand for earnings information.

Does the Business Press Influence Equity Investors’ Perception of Big 4 Audit Quality?

We investigate whether the business press influences equity investors’ perception of the credibility of the Big 4 for providing high-quality audits. We find that the extent of audit-related negative business press coverage of a Big 4 is associated with lower earnings response coefficients (ERC) for clients, negative client abnormal returns on the days of the news release, and a higher percentage of votes against auditor ratification. Importantly, these results are robust to controlling for other information sources such as client news, audit quality indicators (restatements and auditor litigation), and regulator press releases. Also, the extent of Big 4 negative business press coverage is associated with a lower probability of gaining new clients and a greater probability of client misstatements, suggesting that coverage is diagnostic of audit quality. The effects for ERCs and abnormal returns are concentrated in clients with low dedicated institutional ownership and high earnings uncertainty. Overall, this evidence is consistent with the business press influencing investors’ perception of Big 4 audit quality.

Impact of economic policy uncertainty on disclosure and pricing of earnings news

In this paper we examine the effect of economic policy uncertainty on reactions of capital market participants and actions of corporate managers. In particular, we investigate two issues: (1) whether the economic policy uncertainty has a short-term and long-term impact on the interpretation of earnings news and (2) whether the managers strategically time the release of good/bad news to the uncertainty in economic policies. We use a sample of 2973 unique firms from 1990 to 2016 and find that economic policy uncertainty lowers investors’ confidence in earnings, resulting in lower earnings response coefficient. Further test shows that the adverse effect of economic policy uncertainty on earnings informativeness is long-lasting and cannot be explained by the publicly available pre-disclosure information. We also find that firms are more likely to disclose bad news and losses when the economic policy uncertainty is high. These findings are not explained by earnings management and persist even after controlling for commonly used proxies of earnings management. Finally, we show that economic policy uncertainty is distinct from firm-specific uncertainty and that they both have incremental effects on the earnings response coefficient.

Attention to Dividends, Inattention to Earnings?

We examine whether dividends serve as substitutes or complements to accounting information in firm valuation. Consistent with dividends substituting for earnings information, we find that dividend paying firms have 11-15% lower earnings response coefficients (ERCs) than non-payers. We find more substitution when the dividend provides a stronger signal of permanent earnings: when the firm is less likely to cut the dividend, when the firm is likely to fund the dividend out of earnings rather than cash reserves, or when the dividend is larger. We then show dividend payers have lower absolute returns, less trading volume, and fewer analyst forecasts at the earnings announcement (EA), suggesting dividend payers attract less attention to their less informative EAs. Finally, we show that the lower EA attention translates into less earnings management and fewer earnings-related disclosures for dividend payers relative to non-payers. Collectively, this evidence suggests dividends supply information about permanent earnings and, although costly, could be an efficient way for some firms to satisfy investors’ demand for earnings information.

Unexpected SEC Resource Constraints and Comment Letter Quality

ABSTRACTWe investigate whether reviews of transactional filings by the SEC unexpectedly constrain SEC resources, leading to lower quality comment letters for periodic reports. The Sarbanes‐Oxley Act requires the SEC to review periodic reports (e.g., 10‐Ks) at least once every three years. However, the SEC also reviews transactional filings (e.g., initial public offerings and acquisitions), which are unpredictable and often occur in waves. We find comment letters for periodic reports are of lower quality (in terms of outputs, inputs, and firm responses) during periods of abnormally high transactional filings. We also find that comment letters issued during periods of abnormally high versus low transactional filings are associated with increased information asymmetry and lower earnings response coefficients in the quarter after the resolution of the comment letter. Overall, our results suggest that unexpected resource constraints affect the quality of SEC oversight of periodic reports.

SEC Resource Constraints and Comment Letter Quality

We investigate whether reviews of transactional filings by the SEC unexpectedly constrain SEC resources leading to lower quality comment letters for periodic reports. The Sarbanes Oxley Act requires the SEC to review periodic reports (e.g., 10-Ks) at least once every three years. However, the SEC also reviews transactional filings (e.g., IPOs and acquisitions), which are unpredictable and often occur in waves. We find comment letters for periodic reports are of lower quality (in terms of outputs, inputs, and firm responses) during periods of abnormally high transactional filings. We also find that comment letters issued during periods of abnormally high versus low transactional filings are associated with increased information asymmetry and lower earnings response coefficients in the quarter after the resolution of the comment letter. Overall, our results suggest that unexpected resource constraints affect the quality of SEC oversight of periodic reports.

Local Bias in Google Search and the Market Response around Earnings Announcements

ABSTRACTWe examine the impact of distance on internet search, and the effect of the “local bias” in search on the stock market response around earnings announcements. We find significant local bias in search behavior. Motivated by theories explaining local bias, local information advantage, and familiarity bias, we predict and find that firms with higher local bias in search experience higher bid-ask spreads, lower trading volumes, and lower earnings response coefficients at the time of earnings announcements, consistent with non-local investors relying more than locals on public information announcements. Consistent with local information advantage, we find that in the week prior to the announcement, firms with higher local bias have higher bid-ask spreads, higher trading volumes, and returns that are more predictive of the coming earnings surprise. Consistent with familiarity bias, firms with higher local bias in search experience stronger post-earnings announcement drift. We use unique predictions, propensity score matching, and two-stage least squares to identify the effects of local bias separately from the effects of overall visibility. Overall, we show there is significant local bias in search, and that this local bias has a significant impact on the market response around earnings announcements.

Do school ties between auditors and client executives influence audit outcomes?

We identify connected auditors as those who attended the same university as the executives of their clients. Using manually collected data from China, we find that connected auditors are more likely to issue favorable audit opinions, especially for financially distressed clients. Moreover, companies audited by connected auditors report significantly higher discretionary accruals, are more likely to subsequently restate earnings downward, and have lower earnings response coefficients. Lastly, connected auditors earn higher audit fees. Collectively, our evidence suggests the impairment of audit quality when auditors and client executives have school ties and the presence of social reciprocity derived from school ties.

Reputational Implications for Partners After a Major Audit Failure: Evidence from China

We analyze whether audit partners suffered damage to their professional reputations with the demise of Zhongtianqin (ZTQ), formerly the largest audit firm in China, after an audit failure enabled a major client, Yinguangxia (YGX), to fraudulently exaggerate its earnings in a high-profile scandal resembling the Andersen–Enron events in the US. This involves evaluating whether the reputational damage sustained by partners implicated in the scandal spreads to other partners in the same audit firm. We isolate whether impaired reputation impedes partners who were not complicit in the ZTQ–YGX events from attracting new clients or keeping existing ones. Our evidence implies that the market shares of these partners fell after ZTQ’s collapse, supporting that guiltless partners’ reputations were tarnished. We also find that these partners are less likely to be employed by reputable audit firms. The clients of these partners tend to have lower earnings response coefficients, implying that investors downgrade the perceived quality of their audits. Moreover, compared to a matched sample, the former ZTQ partners tend to charge lower audit fees after the firm’s collapse. Finally, we exploit the unique structure of ZTQ to provide evidence consistent with the prediction that the former partners from the branch that handled the YGX audits experienced worse damage to their reputations. In a setting with minimal auditor discipline stemming from civil litigation, our results lend support to the intuition that partners’ reputation concerns motivate them to protect audit quality by closely monitoring other partners in the firm.

The effects of harmonization and convergence with IFRS on the timeliness of earnings reported under Chinese GAAP

This study examines the effects of a series of harmonization and convergence with IFRS on the timeliness of recognition of earnings in emerging Chinese markets. We find that earnings reported under Chinese GAAP have a lower earnings response coefficient, but a higher future earnings response coefficient, than earnings reported under IFRS before Chinese GAAP converged with IFRS in 2007. This indicates that earnings reported under Chinese GAAP are generally less timely than earnings reported under IFRS before convergence. We also find that the future earnings response coefficient of earnings reported under Chinese GAAP continues to increase, indicating that the timeliness of recognition of earnings reported under Chinese GAAP worsened after a series of harmonization and convergence with IFRS in China. Taken together, this study provides evidence indicating that harmonizing and converging national accounting standards with IFRS in emerging capital markets may not necessarily increase accounting quality.

Implications of strategic alliances for earnings quality and capital market investors

Strategic alliances are well-established organizational forms and a means of strategy implementation. Despite their growing pervasiveness in the economy, existent literature provides few insights about earnings quality of strategic alliances. This challenge is especially severe in contractual alliances (CAs), where firms do not form a new corporate entity that is separate from the parent organization in comparison to joint ventures (JVs). We investigate how earnings attributes differ depending on involvement in strategic alliances of 8137 CAs and 3026 JVs spanning 1997–2007. We find, in particular, that earnings attributes of firms involved in contractual alliances are broadly reflective of low underlying accounting quality. Relative to JV firms and non-alliance (NA) firms, they have higher levels of discretionary accruals, lower accrual quality, and earnings that are less persistent, less smooth, less relevant, less timely, and less conservative. They also have lower earnings response coefficients.

Do School Ties between Auditors and Client Executives Influence Audit Quality?

We identify connected auditors as those who attended the same university as the executives of their clients. Using manually collected data from China, we find that connected auditors are more likely to issue favorable audit opinions, especially for financially distressed clients. Moreover, companies audited by connected auditors report significantly higher discretionary accruals, are more likely to subsequently restate earnings downward, and have lower earnings response coefficients. Lastly, connected auditors earn higher audit fees. Collectively, our evidence suggests the impairment of audit quality when auditors and client executives have school ties and the presence of social reciprocity derived from school ties.

Does beating cash flow benchmarks reduce the cost of debt?

ABSTRACTThis paper examines whether beating previous year cash flow values and analysts' cash flow forecasts impact the firms' cost of debt. Creditors are expected to be more concerned about firm solvency than firm profitability. Accordingly, if lenders have any reference point it may be related to cash flow numbers. This study finds that firms that beat analysts' cash flow forecasts have smaller initial bond yield spreads in the next period and a decrease in their initial bond yield spreads between consecutive periods. This effect is more pronounced at short maturities and for observations with less informative earnings. Firms with lower earnings response coefficients that beat analysts' cash flow forecasts show a higher probability of a credit rating upgrade.

The Effects of the Fasb's Relaxation of Fair Value Rules on the Quality of U.S. Bank Earnings

In the face of political pressure in 2009, the FASB relaxed fair value rules to give managers more discretion in measurement of fair value. Supporters argued that the accounting regulatory change would help convey managers’ private information on the measurement of fair values, while critics of the change were concerned that the increased managerial discretion would be opportunistically exploited by managers to achieve regulatory forbearance. This study investigates these two assertions by examining the impacts of relaxing fair value rules on the quality of earnings. Using a sample of U.S. bank holding companies we find that an apparent increase in managerial discretion in fair value is associated with a lower earnings response coefficient during the three-day window around earnings announcements and a higher probability of meeting analysts’ forecasts. Overall, the results indicate that the relaxation of fair value measurement rules adversely impacted the quality of financial reporting by U.S. banks.

The Role of the Audit Committee in Moderating the Negative Effect of Non-Audit Services on Earnings Quality

This paper examines the effect of audit committee effectiveness on the relationship between non-audit services (NAS) and the quality of earnings. We hypothesize that audit committee effectiveness will mitigate the adverse effects of the provision of NAS on the quality of reported earnings. This study uses a sample of 455 firms listed on Bursa Malaysia in the year 2010. Audit committee effectiveness is measured using the Principal Component Method based on four audit committee variables: the size of the audit committee, the proportion of outsiders on the committee, the total number of audit committee meetings during the year, and the attendance rate for audit committee meetings. Examination on the dataset reveals that NAS adversely affects the quality of accounting information, in terms of the lower earnings response coefficient (ERC). The statistical tests also show that this negative relationship becomes weaker when the firms have a more effective audit committee. The results are robust even after controlling for firm growth, risk, earnings variability, earnings losses, and the likelihood of debt covenant violation. In short, this study provides evidence that investors did perceive NAS as impairing auditor independence, and that the inverse effect would be reduced by setting up a more effective audit committee.

Do Audit Partners Share Reputation Jointly and Severally with Other Partners in the Firm?

We analyze whether audit partners suffered damage to their professional reputations with the demise of Zhongtianqin (ZTQ), formerly the largest audit firm in China, after an audit failure enabled a major client, Yinguangxia (YGX), to fraudulently exaggerate its earnings in a high-profile scandal resembling the Andersen-Enron events in the U.S. This involves evaluating whether the reputational damage sustained by partners implicated in the scandal spreads to other partners in the same audit firm. We isolate whether impaired reputation impedes partners who were not complicit in the ZTQ-YGX events from attracting new clients or keeping existing ones. Our evidence implies that the market shares of these partners fell after ZTQ’s collapse, supporting that guiltless partners’ reputations were tarnished. We also find that these partners are less likely to be employed by reputable audit firms. The clients of these partners tend to have lower earnings response coefficients, implying that investors downgrade the perceived quality of their audits. Moreover, compared to a matched sample, the former ZTQ partners tend to charge lower audit fees after the firm’s collapse. Finally, we exploit the unique structure of ZTQ to provide evidence consistent with the prediction that the former partners from the branch that handled the YGX audits experienced worse damage to their reputations. In a setting with minimal auditor discipline stemming from civil litigation, our results lend support to the intuition that partners’ reputation concerns motivate them to protect audit quality by closely monitoring other partners in the firm.

Management Compensation And Project Life

<p class="MsoNormal" style="text-align: justify; margin: 0in 0.5in 0pt; mso-hyphenate: none;"><span style="font-family: "Times New Roman","serif"; letter-spacing: -0.15pt; color: black; font-size: 10pt;">The goal of this paper is to empirically examine the relation between management compensation and project life.<span style="mso-spacerun: yes;">  </span>Prior theoretical research suggests that short-term compensation, in the form of bonus plans, have a tendency to induce managers to invest in projects with short lives. Initially, we develop a model that relates management compensation, earnings announcement and project life defined in terms of duration.<span style="mso-spacerun: yes;">  </span>Our testable hypothesis states that a greater weight placed on short-term compensation induces managers to invest in projects with shorter duration and is reflected in a lower earnings response coefficient (ERC) for a concurrent earnings announcement. We empirically examine whether there is a relation between type of managerial compensation and ERC. After controlling for the firm's investment opportunity set and other variables known to affect the ERC, we find strong evidence indicating a negative relation between project life and the fraction of short-term compensation in the total compensation package.<span style="mso-spacerun: yes;">  </span>This result provides evidence that managers with greater proportionate earnings-based compensation tend to invest in shorter-term projects.</span></p>

IT Internal Control Weaknesses and Firm Performance: An Organizational Liability Lens

The information systems literature and the public press have called for organizations to more closely scrutinize their information technology (IT) controls; however, little more than anecdotal evidence exists on the business value of IT internal control investments, beyond regulatory compliance. Drawing on the strategy and accounting literature, we (a) advance a strategic necessity perspective to the question of IT internal controls value; and (b) use the unique setting provided by the enactment of the Sarbanes-Oxley Act of 2002 (SOX) to investigates the relationship between IT internal control weaknesses (ICW) and both accounting earnings (a contemporaneous measure of firm performance) and market value (a forward looking, risk-adjusted measure of firm performance). Using a data set that provides audited annual assessments of the effectiveness of both IT and non-IT internal controls for a cross-section of companies as mandated by SOX, we find that firms that report an IT ICW have lower accounting earnings compared to firms with strong IT internal controls. We also find that IT ICW moderates the association between accounting earnings and market valuation, with firms reporting weak IT internal controls having a lower earnings response coefficient. These results are sustained even after controlling for non-IT ICW and firm-specific factors that are known determinants of ICW. The results are also robust to econometric corrections for potential simultaneity and self-selection bias using Heckman’s two-stage procedure. Overall, our results provide empirical evidence which suggests that IT internal controls are a strategic necessity and that information systems risk is priced by the capital markets.

HUBUNGAN INFORMASI PELAPORAN EARNINGS AKUNTANSI TERHADAP PERGERAKAN RETURNS SAHAM PADA PERUSAHAAN MANUFAKTUR DI BURSA EFEK JAKARTA

The purpose of this research is to know whether the negative earnings stock have lower sensitivity level or lower Earnings Response Coefficient (ERC) to stock return than the positive earnings stock and this research also aim to know whetherthe negative earnings stock will have weaker level strength of correlation (R2) to stock return than the positive earnings stock. The samples are 25 fisted manufactured company at Jakarta Stock Exchange during 2000-2004 which selected using purposive non random sampling. Data analyze method used is linier regression. The result of this research is that the negative earnings stock will have the lower level sensitivity or lower Earnings Response Coefficient (ERC) to stock return, compared to the level sensitivity (ERC) of positive earnings stock This research also finds that the negative earnings stock will have weaker level strength of correlation (R2) to stock return, compared to the level strength of correla­tion (R2) of positive earnings stock.Keywords: Negative earnings, Positive earnings, Stock return, Earnings response coefficient, Return-earnings association