Negative Earnings Surprises Research Articles

Effects of Qualitative Factor Salience, Expressed Client Concern, and Qualitative Materiality Thresholds on Auditors' Audit Adjustment Decisions*

We conduct an experiment to provide evidence on factors that influence auditors' propensity to book or waive audit differences that affect the client's ability to meet the analysts' consensus forecast and avoid a negative earnings surprise. Results indicate that increasing the salience of a qualitative materiality factor (by highlighting the audit difference's impact on the client's ability to meet the analysts' consensus forecast) increases auditors' propensity to book the audit difference, but only for auditors with lower qualitative materiality thresholds (i.e., the thresholds that auditors use to assess qualitative materiality). Further, the presence of expressed client concern about the adverse consequence of booking the audit difference is found to attenuate the effect of increased salience of the qualitative factor for these auditors. These findings contribute to a better understanding of why auditors may (or may not) waive quantitatively immaterial but qualitatively material audit differences, and the boundary conditions under which mechanisms for enhancing auditors' audit adjustment decisions work (or may not work).

Do Pennies Matter? Investor Relations Consequences of Small Negative Earnings Surprises

We study earnings - conference-call characteristics to understand the investor - relations consequences of small negative earnings surprises. Our study is motivated by the lack of empirical evidence supporting the notion that capital markets excessively punish firms that miss earnings targets by small amounts (Skinner and Sloan 2002, Kinney et al. 2002) despite managerial claims that such punishment exists (Graham et al. 2005). We view conference calls as a particularly powerful setting to investigate claims of asymmetric investor-relations effects for missing analyst expectations. We find a significant increase in call length for firms that miss analyst expectations by one cent compared to the increase in adjacent one-cent intervals. This increase is more pronounced for firms with higher analyst following. We also find that firms just missing expectations are about 5% less likely to offer future earnings guidance around the conference call. However, we find no statistically significant evidence that the tone of the call is asymmetrically more negative for firms that just miss expectations. We confirm these findings by examining whether the discussion between managers and individual analysts is related to whether the expectation of that particular analyst is met. In sum, while we find some statistical evidence to confirm the survey results of Graham et al. (2005) regarding the asymmetrically negative effects of missing expectations, our tests do not suggest that severe economic effects result from just missing expectations.

Earnings Surprises and Changes in Liquidity

The magnitude and direction of earnings surprises are related to changes in liquidity arising from changes in adverse selection. Shares of firms with extreme earnings surprises experience larger increases in adverse selection than shares of firms with moderate earnings surprises in the short interval during the earnings announcements, suggesting that the extremeness of earnings surprises creates uncertainties that increase adverse selection. These changes in adverse selection are highly transitory. In the longer term, adverse selection decreases (increases) for firms with positive (negative) earnings surprises, consistent with the expected changes in the economic and information environment of firms with different earnings surprises.

Is the value relevance of earnings conditional on the timing of earnings information?

We examine the association between quarterly stock returns and total earnings news conditional on the timing in which earnings information is revealed to the market. Evidence in prior research suggests that managers try to avoid reporting a negative earnings surprise and that market participants place greater weight on the information contained in earnings announcements than on earnings forecast revisions during a quarter (Soffer, L., Thiagarajan, R., Walther, B., 2000. Earnings preannouncement strategies. Review of Accounting Studies 5 (1), 5–26; Bartov, E., Givoly, D., Hayn, C., 2002. The rewards to meeting or beating earnings expectations. Journal of Accounting and Economics 33 (2), 173–204). This notion is consistent with recency theory in the context of individual judgment and decision-making behavior (Hogarth, R., Einhorn, H. 1992. Order effects in belief updating: The belief-adjustment model. Cognitive Psychology 24 (1), 1–55). We extend prior research by investigating the descriptive validity of recency theory to a comprehensive set of potential earnings paths. Our evidence suggests, contrary to conclusions in the prior literature, that investors do not always assign more weight to earnings surprises than to analyst forecast revisions. Rather, our results suggest that the market response to earnings news is more consistent with prospect theory, an alternative cognitive psychology theory developed by Kahneman and Tversky (1979. Prospect theory: An analysis of decisions under risk. Econometrica 47 (2), 263–292).

Effects of Qualitative Factor Salience, Expressed Client Concern, and Qualitative Materiality Thresholds on Auditors' Audit Adjustment Decisions

We conduct an experiment to provide evidence on factors that influence auditors' propensity to book or waive audit differences that affect the client's ability to meet the analysts' consensus forecast and avoid a negative earnings surprise. Results indicate that increasing the salience of a qualitative materiality factor (by highlighting the audit difference's impact on the client's ability to meet the analysts' consensus forecast) increases auditors' propensity to book the audit difference, but only for auditors with lower qualitative materiality thresholds (i.e., the thresholds that auditors use to assess qualitative materiality). Further, the presence of expressed client concern about the adverse consequence of booking the audit difference is found to attenuate the effect of increased salience of the qualitative factor for these auditors. These findings contribute to a better understanding of why auditors may (or may not) waive quantitatively immaterial but qualitatively material audit differences, and the boundary conditions under which mechanisms for enhancing auditors' audit adjustment decisions work (or may not work).

Anomalous Price Behavior Following Earnings Surprises: Does Representativeness Cause Overreaction?

Behavioral Finance aims to explain empirical anomalies by introducing investor psychology as a determinant of asset pricing. Two kinds of anomalies, namely underreaction and overreaction, have been established by an impressive record of empirical work. While underreaction defines a slow adjustment of prices to corporate events or announcements, overreaction deals with extreme stock price reactions to previous information or past performance.This study investigates current and past earnings surprises for listed US companies over the period 1983-1999. It provides evidence that investors exhibit long-term overreaction to past, highly unexpected, earnings surprises. Investors tend to overestimate (underestimate) future earnings after extreme positive (negative) earnings surprises. As, on average, these extreme past surprises are not confirmed by subsequent earnings figures, they are followed by a correction of the initial overreaction at the date of the subsequent earnings announcement. Moreover, the longer the similar earnings surprise series, the higher the subsequent correction, suggesting that representativeness may cause this overreaction phenomenon.

Anomalous Price Behavior Following Earnings Surprises: Does Representativeness Cause Overreaction?

Behavioral Finance aims to explain empirical anomalies by introducing investor psychology as a determinant of asset pricing. Two kinds of anomalies, namely underreaction and overreaction, have been established by an impressive record of empirical work. While underreaction defines a slow adjustment of prices to corporate events or announcements, overreaction deals with extreme stock price reactions to previous information or past performance. This study investigates current and past earnings surprises for listed US companies over the period 1983-1999. It provides evidence that investors exhibit long-term overreaction to past, highly unexpected, earnings surprises. Investors tend to overestimate (underestimate) future earnings after extreme positive (negative) earnings surprises. As, on average, these extreme past surprises are not confirmed by subsequent earnings figures, they are followed by a correction of the initial overreaction at the date of the subsequent earnings announcement. Moreover, the longer the similar earnings surprise series, the higher the subsequent correction, suggesting that representativeness may cause this overreaction phenomenon.

Strategic Coordination of Good and Bad News Disclosures: The Case of Voluntary Patent Disclosures and Negative Earnings Surprises

Firms enjoy a wide degree of discretion in their disclosure of events in the patent granting process, which investors generally view as good news announcements. This study examines the timing of patent disclosure in conjunction with earnings announcements in light of managers' incentives to avoid the stock price-related consequences of earnings disappointments. Among a sample of firms making voluntary patent disclosures, the results suggest that the likelihood of disclosing a patent before a bad news earnings announcement increases in the magnitude of the negative earnings surprise. Further, such strategic patent disclosure appears to successfully dampen the market response to the earnings disappointment. Overall, the empirical findings suggest that some firms strategically time the voluntary disclosure of patent-related information in order to manage their short-term stock prices before an adverse information event.

Management of Earnings and Analysts' Forecasts to Achieve Zero and Small Positive Earnings Surprises

Abstract: This paper corroborates the finding of prior studies that managers avoid reporting earnings lower than analyst forecasts (i.e., negative earnings surprises) and provides new evidence of actions contributing to this phenomenon. Specifically, we provide empirical evidence of both (1) upward management of reported earnings and (2) downward ‘management’ of analysts' forecasts to achieve zero and small positive earnings surprises. Further analysis of the components of earnings management suggests that both the operating cash flow and discretionary accruals components of earnings are managed.

Investigating the return predictability of changes in corporate borrowing

This study investigates the return predictability of changes in corporate borrowing by conditioning it on equity styles. state of market, and earnings expectation to determine whether it is due to unidentified sources of risk or mispricing. We observe that increases in borrowing are indeed followed by declines in operating and risk-adjusted return performance. However, the return underperformance exists only in small-cap growth companies experiencing negative earnings surprise, irrespective of the market state. We extend previous studies by demonstrating that the phenomenon is not pervasive over the entire cross-section of the stock market and is likely to be a manifestation of negative price response against the earnings disappointment of small-cap growth companies. Our results have implications for market efficiency and stock selection.

Anomalous Price Reaction and Differential Stockholder Response to Going-Concern Audit Opinions and Withdrawals

We explore the medium-term market reaction to going-concern modified audit opinions and their withdrawal for a large sample of firms from 1994 to 2002. Results show asymmetric market response to these accounting system disclosures. The market underreacts to going-concern opinions, resulting in a subsequent downward drift of around -16% over the one-year period subsequent to the going-concern opinion, but fully anticipates their withdrawal. This post-going-concern announcement drift is distinct from other established anomalies; however, it is limited to those going-concern cases with negative earnings surprise. Nonetheless, adjusting for transactions costs, the opportunity to earn profits by trading on this anomaly is limited and risky. Analysis of stockholder trading activities reveals that institutions reduce their holdings in such stocks on a timely basis in contrast to retail investors. Our results are original, and indicate that auditors are providing clear messages to financial statement users in the going-concern context but their information content is not being fully impounded by the market on a timely basis.

Investor Inattention, Firm Reaction, and Friday Earnings Announcements

Do firms release news in response to investor inattention? We consider news about earnings and analyze the response of returns to announcements on Friday and other weekdays. Friday announcements have less immediate and more delayed response. The delayed response as a percentage of the total response is 60 percent on Friday and 40 percent on other weekdays. In addition, trading volume around announcement day increases 10 percent less for Friday announcements. These findings suggest that weekends distract investor attention temporarily. They support explanations of post-earning announcement drift based on underreaction to information caused by limited attention. We also document that firms release worse announcements on Friday. Friday announcements are associated with a 45 percent higher probability of a negative earnings surprise and a 50 basis points lower abnormal return. The firm-based evidence of strategic news release supports the investor-based finding of inattention on Friday. The results for stock returns, volume, and strategic behavior support the hypothesis of limited attention.

Earnings Management to Avoid Negative Earnings Surprises in Periods Following Insider Sales

This paper investigates whether insiders manage earnings in the quarters following their stock sales in order to mitigate earnings shocks. An insider trade followed closely by potentially value-relevant earnings disclosures gives the appearance that the trade was based on foreknowledge of the soon-to-be disclosed information. Because securities laws prohibit such trade insiders have incentives to avoid the appearance that their stock transactions are based on private information. I examine a sample of 18,349 firm quarters that correspond to insider sale or post-sale periods over the period January 1989 through July 2001. I compare properties of earnings for these sample observations to non-sale controls matched on industry, time, size and performance. I find increased levels of abnormal accruals in the periods subsequent to insider sales, and that these positive accruals are associated with analyst forecast errors whose values are indistinguishable from those of matched control firms but whose magnitudes are significantly smaller. This pattern suggests insiders manage earnings in order to distance their sales from negative earnings news consistent with avoidance of the appearance of illegal insider trade.

Investors' Differential Reaction to Positive Versus Negative Earnings Surprises

Archival studies document an asymmetrically strong market reaction to positive vis-a-vis negative earnings surprises. This finding appears inconsistent with the well-known effect of loss aversion and remains unexplained. I contend that this reaction pattern can arise when investors' earnings expectations do not coincide with analyst forecasts. Numerous studies document optimistic biases in analyst forecasts. If investors perceive optimistic biases in analyst forecasts, their earnings expectations will be lower than analyst forecasts. Because the contrast between the obtained and the expected outcome determines the degree of perceived surprise, an investor expectation which is below the analyst forecast results in a larger (smaller) perceived earnings surprise than reported when the surprise is positive (negative). Investors' lower expectations relative to analyst forecasts therefore result in a stronger reaction to positive than to negative reported earnings surprises of equivalent magnitude. In a controlled experiment, I replicate the asymmetrically strong reaction to positive reported earnings surprises, and trace this reaction pattern to investors' perceptions of these surprises. I further show that when earnings surprises are measured based on investors' perception of those surprises, the differential reaction pattern reverses: investors react asymmetrically strong to negative vis-a-vis positive perceived earnings surprises, consistent with loss aversion. My findings carry implications for investors and accounting researchers.

Institutional Investment Horizons and CEO Compensation

I investigate the relation between the structure of CEO compensation and the investment horizons of a firm's institutional investors and find results consistent with the assertion that short-sighted institutions' focus on short-term earnings leads firms to grant more options with higher sensitivity to stock price. In contrast, the percentage holdings of long-term investors are negatively correlated with the use of options and the sensitivity of total CEO equity incentives to changes in stock price. Further results suggest that firms with higher short-term institutional ownership are more concerned about a negative earnings surprise and that when determining annual bonuses, they punish their CEOs more severely. In total, the analyzes provide evidence that the investment horizon of institutional investors is associated with firms' CEO compensation policies.

The Composition of Institutional Ownership and the Structure of CEO Compensation

I examine the relation between the composition of institutional ownership and the structure of CEO compensation. Consistent with my hypotheses, I find that firms with more shares held by institutions with longer investment horizons place more weight on forward-looking performance measure in determining CEO cash compensation. I also find that the percentage holdings by transient institutions, dedicated institutions, investment advisors and pension and endowment are positively associated with the percentage of CEO compensation that is equity-based. These findings continue to hold after I control for potential simultaneity bias. Finally, the results suggest that the boards of firms with higher transient institutional ownership appear to be more concerned about a negative earnings surprise and punish their CEOs more severely in determining annual bonuses. Combined, the analyses provide compelling evidence that the board considers the composition of external shareholders and their likely preferences for executive compensation policies.

The Role of Analysts in Differentially Interpreting Earnings Surprises

It is commonly believed that relatively large absolute earnings surprises trigger more differential interpretations compared to small earnings surprises (e.g., Bamber 1987; and Morse et al. 1991). However, prior research provides no direct support for this belief. This study tests the prediction that, when forecasting future earnings, the weight the average analyst places on their own idiosyncratic information processing skills (or the degree to which they differentially interpret earnings) increases more after relatively large absolute earnings surprises. This prediction is based on the argument that less persistent earnings surprises (in this case relatively large earnings surprises) cause analysts to rely less heavily on the information commonly observed in earnings surprises, and to rely more heavily on their own idiosyncratic information processing skills. Using forecasts of quarterly earnings, we examine changes in the relative weight analysts place on their private information around prior quarterly earnings announcements. Consistent with our expectations, we show that the weight analysts place on their private information increases more after relatively large earnings surprises compared to small earnings surprises. We also show that the weight analysts place on their private information increases more after negative earnings surprises, which are also less persistent. Our evidence suggests that the relative importance of analysts' interpretive informational role varies across earnings announcements, and is more prevalent when there is likely to be more demand for analysts' differential interpretations. We show that this effect serves to improve the accuracy of the mean forecast.

Strategic Release of Information on Friday: Evidence from Earnings Announcements

Do firms time the release of news in response to investor inattention? We consider news about earnings and analyze the reaction of investors to announcements on Friday and on other weekdays. The day of the week for the announcement has two main effects on stock returns. First, the short-term response to Friday earnings announcements is 20 percent smaller than the response on other days of the week. Second, the post-earnings drift is 70 percent larger for Friday announcements. These stylized facts suggest that weekends distract investor attention temporarily. Consistent with this interpretation, trading volume around announcement day increases 20 percent less for Friday than for non-Friday announcements. The empirical evidence supports models of post-earning announcement drift based on underreaction to information due to cognitive constraints. We also show that firms appear to respond to investor distraction by releasing worse announcements on Friday. Friday releases are associated with a 25 percent higher probability of a negative earnings surprise and a 50 basis points lower abnormal stock return. Finally, we document a similar pattern of strategic behavior for political decisions. The US President is 25 percent less likely to sign executive orders or legislation containing good news on Friday.

The Relation between Dispersion in Analysts' Forecasts and Stock Returns: Optimism Versus Drift

This paper investigates the conclusion in Diether, Malloy, and Scherbina (2002) that dispersion in analysts' forecasts proxies for differences in investor beliefs, and that prices reflect the beliefs of optimistic investors when dispersion is high. If this is the case, we expect to find higher earnings response coefficients (ERCs), related to negative earnings surprises, for high versus low dispersion firms. This follows because the negative earnings surprises are less consistent with the beliefs of optimists. However, we find smaller ERCs, which calls into question the optimism argument in DMS. Further, we find that the relatively low future returns earned by high forecast dispersion firms, documented in DMS, are explained by the well known post-earnings-announcement drift phenomena. Specifically, after sorting observations based on prior period standardized unexpected earnings (SUEs), which are associated with drift, the difference between the future returns of high versus low dispersion firms is not statistically significant.

Capital Gain Tax Overhang and Price Pressure

Capital gains tax can impose potentially large cost on investors selling stocks. This cost can sometimes be an order of magnitude larger than conventional transaction costs. This paper addresses the question of whether capital gains taxes serve as an impediment to selling and if so, to what degree this delayed selling by investors correspondingly affects stock prices. Using a database of large U.S. institutions' stock holdings with data on institutions' client profiles, two main results are obtained. First, selling decisions by institutions serving tax-sensitive clients are shown to be sensitive to their cumulative capital gains, which is not the case for institutions with predominantly tax-exempt clients. In particular, both the likelihood and magnitude of selling by institutions that serve taxsensitive clients are negatively related to the cumulative capital gains. Second, tax-related underselling appears to significantly impact stock prices during negative earnings announcements, for stocks held by a large number of tax-sensitive investors. Specifically, following a negative quarterly earnings surprise, tax-sensitive investors sell less aggressively a stock that has large capital gains; thus for a stock held primarily by taxsensitive investors, the corresponding price reaction is less negative if it has accumulated large capital gains. Further analysis shows that the price reaction pattern is more severe when arbitrage is more costly.