Behavior of earnings, stock returns, accruals, and analysts' forecasts following negative annual earnings

Abstract

This study documents the behavior of earnings, abnormal stock returns, analysts' earnings forecasts, and accounting accruals following years in which companies report negative annual earnings. Changes in accounting accruals (earnings minus operating cash flows) frequently are used as proxies for managerial manipulation of earnings numbers. Our evidence indicates that earnings typically increase sharply in the year following a loss. The earnings increases are due to improved operating cash flows, not to accounting “window dressing.” However, financial analysts expect even better earnings performance than the rebounding firms are able to provide. Investors also appear not to understand the post‐loss behavior of annual earnings. Therefore, the market commonly is disappointed by the earnings increases, and the result, on average, is negative excess stock returns. The excess returns are correlated with analysts' earnings forecast errors, which proxy for the market's failure to understand post‐loss earnings behavior.

Opaque financial reports and R2: Revisited

“…33While other accruals estimation methods have been employed (Ettredge, Toolson, Hall, & Na, 1996), the primary techniques in the literature are the modified Jones model and the Kothari et al (2005) model. More recently, Dechow, Hutton, Kim, and Sloan (2012) developed a new technique to estimate discretionary accruals.…”