This study investigates how investors in the market react to earnings management (hereafter, EM) and whether analysts provide added value to the market in interpreting EM information. We consider whether evidence of EM in financial statements influences market prices and returns, and whether analysts provide investors with incremental information that may help them assess the integrity of reported earnings.
Following Balsam et al. (2002), we focus on market reaction to the release of the full set of financial statements, and not to earnings announcements, as the latter may not include sufficient information (e.g., balance sheet and/or cash flow information) that can be used to disentangle the consequences of EM (see also, e.g., Baber et al., 2006; Balsam et al., 2002). Balsam et al. (2002) show that sophisticated investors as well as unsophisticated investors (proxied by the level of institutional ownership) are unable to recognize earnings management around earnings announcement date.
Literature on market reaction to EM includes two strands of research; studies that examine the associations between security returns and accruals or accruals management in the context of long window designs (Sloan, 1996; Subramanyam, 1996; Rangan, 1998; Teoh et al., 1998a,b; Xie, 2001) and studies that examine these associations in the context of short-window designs (DeFond and Park, 2001; Balsam et al., 2002; Baber et al., 2006). Sloan (1996) provides evidence that investors naively”fixate”on earnings,”failing to distinguish fully between the different properties of the accrual and cash flow components of earnings”.
Hence, stocks of firms with relatively high (low) levels of accruals are overpriced (underpriced), and given the differential persistence in cash flows and accruals, these stocks experience negative (positive) future abnormal returns around future earnings announcements. Xie (2001) also finds that the market overestimates the persistence (one-year-ahead earnings implications) of discretionary accruals, consequently overpricing these accruals. Rangan (1998) and Teoh et al. (1998a,b) investigate the long-run price effects of discretionary accruals in the context of equity issues and show that investors are deceived by EM. Subramanyam (1996) documents a positive correlation between annual discretionary accruals and twelve-month period stock returns (ending three months after fiscal year-end).
In contrast to long-window studies, the short-window studies attempt to isolate reactions of investors to earnings disclosure to facilitate examination of their ability to detect and react to EM. DeFond and Park (2001) find higher (lower) earnings response coefficients (ERCs) when abnormal accruals – unexpected working capital suppress (exaggerate) the magnitude of earnings surprises,”consistent with market participants anticipating the reversing implications of abnormal accruals”. However, based on analysis of subsequent stock returns, DeFond and Park conclude that market participants do not fully adjust for suspected EM at the earnings announcement date. Balsam et al. (2002) focus on investors' reaction to the release of the full set of financial statements in Form 10-Q (quarterly report), rather than on the reaction to the earnings announcement, because the Form 10-Q filing with the SEC provides information that can be used to asses the integrity of reported earnings. Balsam et al. find that unsophisticated investors, as indicated by low institutional ownership, react to EM revealed in the disclosure of financial statements; specifically, they document a negative association between evidence of EM and cumulative abnormal returns over a 17-day window around the 10-Q filing date (CAR(-1,+15)).
In contrast, sophisticated investors react prior to this date (over a period ending two days prior to the filing date of Form 10-Q with the SEC). According to Balsam et al., the reaction of sophisticated investors precedes the release of Form 10-Q, probably due to their access to”other, more timely sources of information (e.g., conference calls and private conversations with management).”Baber et al. (2006) also investigate investor reaction to EM. Like DeFond and Park (2001), they focus on the influence of EM on interpretations of earnings at the time of earnings announcement. They find that security price reactions to quarterly earnings announcements depend on whether balance sheet and/or cash flow information is released concurrently with earnings press releases. Notably, in cases where balance sheet and/or cash flow information is voluntarily released, the negative price reaction to upward managed earnings is more substantial and more significant statistically. Baber et al. conclude that”investors attempt to price-protect themselves against EM, and that their ability to do so is enhanced when firms disclose information that can be used to disentangle the consequences of EM”.
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