[This paper examines the relation between stock returns and accounting earnings under the assumption that the market observes current-period information other than earnings. This assumption is motivated by existing empirical evidence that stock returns lead accounting earnings. The analysis shows that the returns-earnings relation depends on the relative ability of earnings versus alternative information to predict future earnings as well as the time-series persistence of earnings. Assuming that the researcher does not observe the alternative information, the earnings response coefficient should be increasing both in the ability of past earnings to predict future earnings and in earnings persistence. The variance of stock price changes during the announcement of earnings should be decreasing in predictability and increasing in persistence. Empirical tests of these four hypotheses are generally consistent with the theory. Also discussed is how the assumption of alternative information may be useful in examining the information environment hypothesis, in assessing ad hoc methods of reducing measurement error bias, and in formulating how economic earnings differ from accounting earnings.]

Information content, Disclosures, Earnings components

Abstract This paper examines the relation between stock returns and accounting earnings under the assumption that the market observes current-period information other than earnings. This assumption is motivated by existing empirical evidence that stock returns lead accounting earnings. The analysis shows that the returns-earnings relation depends on the relative ability of earnings versus alternative information to predict future earnings as well as the time-series persistence of earnings. Assuming that the researcher does not observe the alternative information, the earnings response coefficient should be increasing both in the ability of past earnings to predict future earnings and in earnings persistence. The variance of stock price changes during the announcement of earnings should be decreasing in predictability and increasing in persistence. Empirical tests of these four hypotheses are generally consistent with the theory. Also discussed is how the assumption of alternative information may be useful in examining the information environment hypothesis, in assessing ad hoc methods of reducing measurement error bias, and in formulating how economic earnings differ from accounting earnings.

Recent studies have provided theory and evidence that the contemporaneous relation between stock returns and accounting earnings is nonlinear, different for profits and losses, and different across firms. Since each factor can result from differences in earnings persistence, existing theory is ambiguous as to whether these factors are distinct or overlapping. Thus, we conduct a simultaneous examination. Our primary tests show that each factor explains a significant portion of the variance of returns after controlling for the other two factors, with firm-specific estimation providing the largest incremental explanatory power. Alternative tests produce similar conclusions. Empirically, the three factors are distinct.