Using Market Reaction to Infer Persistence of Earnings Surprises

The study examines whether consolidating qualified special-purpose entities (QSPEs) under Statement of Financial Accounting Standards Nos. 166 and 167 (FAS 166/167) improves the market reaction to earnings disclosures. We use a difference-in-difference design to compare the change sample, which is defined as banks that consolidate QSPEs after FAS 166/167, with the no-effect sample, which is defined as financial institutions with no QSPEs or banks that do not consolidate QSPEs after FAS 166/167. The results show that, during a short window around earnings announcements, the change sample experiences higher market reaction to earnings surprises than the no-effect sample after the implementation of FAS 166/167. We also find that the effect is more pronounced in banks that engage in securitization and in financial institutions whose securitized loans originate primarily from consumer loans rather than mortgages. Additional analysis also finds that adopting FAS 166/167 enhances the ability of earnings to predict future earnings and future cash flows in banks. The important implication of the study for regulators is that FAS 166/167 improves bank transparency.

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Meeting-or-Beating, Earnings Management, and Investor Sensitivity after the Scandals

Accounting Horizons ◽

10.2308/acch-50822 ◽

2014 ◽

Vol 28 (4) ◽

pp. 847-867 ◽

Cited By ~ 3

Author(s):

Sanghyuk Byun ◽

Kristin Roland-Luttecke

Keyword(s):

Earnings Management ◽

Capital Market ◽

Market Reaction ◽

Data Availability ◽

Market Regulation ◽

Future Performance ◽

Accounting Scandals ◽

Potential Market ◽

Earnings Surprises ◽

Capital Market Regulation

SYNOPSIS We contribute to the literature investigating the market reaction to firms' small positive earnings surprises following the large accounting scandals in the early 2000s. While prior studies provide evidence that the market no longer rewards firms for meeting-or-beating (MBE) in the post-scandal period, their efforts to address the rationality of the market response invite additional analysis. We demonstrate that the change in the market reaction to MBE is consistent with temporary over-skepticism. Specifically, we show that the market does not differentiate between MBE achieved operationally versus through earnings management, despite previously documented differences in future performance. We explore the relation between MBE, earnings management, and future performance in the post-scandal period and find evidence of mispricing consistent with the market underreacting to small positive earnings surprises earned by firms that do not appear to have manipulated earnings to MBE. Our study provides evidence of a potential market anomaly, which should be of interest to financial managers, researchers, and investors, and speaks to capital market regulation. Data Availability: Data are available from sources identified in the paper.

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