Knowledge that Transforms

I show that median earnings surprise has shifted rightward from small negative (miss analyst estimates by a small amount) to zero (meet analyst estimates exactly) to small positive (beat analyst estimates by a small amount) during the 16 years, 1984 to 1999. I show that a rightward temporal shift in median surprise from negative to positive describes earnings, but neither profits nor losses. Median profit surprise shifts within the positive quadrant, from zero to one cent per share. Median loss surprise shifts within the negative quadrant from extreme negative (about ‐33 cents per share) to zero. I show that the median surprise for profits exceeds that for losses in every year. I document significant positive temporal trends in both meet and beat analyst estimates for both profits and losses, but I find a greater frequency of profits that either meet or beat analyst estimates in every year. I find a significant positive temporal trend in positive profits that are “a little bit of good news,” and a significant negative temporal trend in managers who report losses that are an “extreme amount of bad news.” My results are robust to the four internal validity threats I consider—namely temporal changes in: (1) analyst forecast accuracy, (2) the mix of earnings of one sign preceded by earnings of another sign four quarters ago, (3) the timeliness of the most recent analyst forecast, and (4) the I/B/E/S definition of actual earnings. I find that managers of growth firms are relatively more likely than managers of value firms to report good news profits. I show that when they do report positive profit surprises, managers of growth firms are more likely to report “a little bit of good news” in every year.

Prior research suggests that financial analysts’ earnings forecasts and stock prices underreact to earnings news. This paper provides evidence that analysts and investors correct this underreaction in response to the next earnings announcement and to other (non‐earnings‐surprise) information available between earnings announcements. Our evidence also suggests that analysts and investors underreact to information reflected in analysts’ earnings forecast revisions and that non‐earnings‐surprise information helps correct this underreaction as well. Controlling for corrective non‐earnings‐surprise information significantly increases estimates of the degree to which analysts’ forecasting behavior can explain drifts in returns following both earnings announcements and analysts’ earnings forecast revisions.

This paper uses an agency theory model in which the agent's actions are multi‐dimensional to analyze the optimal weights to apply to performance measures in a compensation contract. We show how the optimal contract trades off the congruity of the overall performance measure with the desire to minimize the risk imposed upon the agent. In contrast to the single action case, we find that an increase in the sensitivity of a performance measure to an agent's action does not necessarily increase the weight placed on that performance measure, even if that measure is perfectly congruent with the firm's outcome.

This study reports the results of an experiment showing that auditor assessments of litigation risk and planned audit investments are higher when potential errors overstate financial performance than when those errors understate performance. This result is much stronger in the presence of high levels of litigation risk in the client’s industry. These results suggest that in industries where litigation risk is high audited financial statements may contain more unintentional material understatement errors than overstatement errors. Thus, litigation risk—through its effect on auditors—may encourage financial statements that understate firm performance

We model a two‐period pure exchange economy where a risk averse manager, who has private information regarding future earnings, is required to issue an earnings report to investors at the end of each period. While the manager is prohibited from directly disclosing her private information, she is allowed to bias reported earnings in the first period, subject to GAAP rules that require that a specified proportion of the bias be reversed subsequently. We show there is a minimum threshold of reversal, such that, when the proportion of required reversal is above this threshold, the manager smooths income and communicates her private information through reported earnings. Consequently, the market attaches greater weight to reported earnings than under a regime that allows no discretion. When the required reversal is below the minimum threshold, the manager increases reported earnings without limit and the equilibrium degenerates. When the manager is not endowed with any private information, the market unravels the “true” earnings and price is unaffected by earnings management. Our results underscore the importance of both allowing and restricting reporting discretion through formal mechanisms.