Prior research suggests that the earnings expectations of a segment of the market can be described by the seasonal random-walk model. Prior research also provides evidence that less wealthy and less informed investors tend to make smaller trades (small traders) than wealthier and betterinformed investors (large traders). I hypothesize that it is the earnings expectations of small traders that are associated with predictions from the seasonal random-walk model. By directly analyzing the trading activities of small and large traders, this study provides evidence that is largely consistent with the hypotheses. Specifically, small traders' trading response around earnings announcements is increasing in the magnitude of seasonal random-walk forecast errors, even after controlling for absolute analyst forecast errors, contemporaneous price changes, and market-wide trading. Supplementary analysis reveals that this effect is largely confined to firms with relatively impoverished information environments (i.e., smaller firms and firms with little to moderate analyst following).

Information asymmetry in financial markets relates to the idea that one party to a transaction has better information than the other. Since financial reporting involves the transmission of value relevant enterprise information, we investigate whether the quality of reported earnings can contribute to differentially informed financial market participants. Higher information asymmetry is costly as it increases the adverse selection risk for market participants and lowers liquidity. For a large sample of NYSE and NASDAQ firms, we show that (i) poor earnings quality is significantly and incrementally associated with higher information asymmetry, (ii) earnings quality disproportionately affects information asymmetry for firms with poor information environments, (iii) both innate and discretionary components of earnings quality increase information asymmetry, and (iv) poor earnings quality exacerbates the information asymmetry around earnings announcements. Our results suggest that the standard setters’ efforts to develop accounting standards that improve earnings quality should contribute to a better information environment for market participants and increase stock liquidity.

Using path analysis, we investigate the direct and indirect links between three measures of earnings quality and the cost of equity. Our investigation is motivated by analytical models that specify both a direct link and an indirect link that is mediated by information asymmetry, but do not suggest which link would be more important empirically. We measure information asymmetry as both the adverse selection component of the bid-ask spread and the probability of informed trading (PIN). For a large sample of Value Line firms during 1993–2005, we find statistically reliable evidence of both a direct path from earnings quality to the cost of equity, and an indirect path that is mediated by information asymmetry, with the weight of the evidence favoring the direct path as the more important.

In recent years, many companies have emphasized adjusted-GAAP earnings numbers in their quarterly press releases. While managers use different names to describe these nonstandard earnings metrics, the financial press frequently refers to them as “pro forma” earnings. Managers and other advocates of pro forma reporting argue that these disclosures provide a clearer picture of companies' core earnings. On the other hand, regulators, policymakers, and the financial press often allege that managers' pro forma earnings disclosures are opportunistic attempts to mislead investors. Recent evidence suggests that while many pro forma earnings disclosures are altruistically motivated, some may represent managers' attempts to portray overly optimistic financial performance. If this is the case, then less wealthy, less sophisticated, individual investors are arguably the most at risk of being misled. Consequently, this study investigates who trades on pro forma earnings information. Our intraday investigation of transactions around earnings announcements containing pro forma earnings information reveals that less sophisticated investors' announcement-period abnormal trading is significantly positively associated with the magnitude and direction of the earnings surprise based on pro forma earnings. In contrast, we find no association between sophisticated investors' trading and manager-reported pro forma information. Overall, our analyses and numerous robustness tests suggest that the segment of the market that relies on pro forma earnings information is populated predominantly by less sophisticated individual investors. This evidence is particularly relevant to standard-setters and regulators given that Section 401(b) of the Sarbanes-Oxley Act of 2002 and subsequent SEC regulations are specifically designed to protect ordinary investors from misleading pro forma information.