Anticipated Circle

Discussing Patricia M. Dechow and Douglas J. Skinner paper, “Earnings Management: Reconciling the View of Accounting Academics, Practitioners and RegulatorsAccounting Horizons 14:2 (2000), pp. 235-250, in Accounting Theory class. At page 244:

First, Barth et al. (1999) find that, otber things equal, firms reporting continuous growth in annual earnings are priced at a premium to other firms, that this premium increases with the length of the string, and that tbe premium is reduced when the string disappears. Second, Skinner and Sloan (2000) document that the stock price response to adverse earnings surprises is disproportionately large for growth stocks. Thus, when growth stocks report even small earnings disappointments (relative to analysts’ forecasts) they suffer disproportionately large stock price declines. Skinner and Sloan (2000) interpret their evidence as being consistent with the idea in Lakonisbok et al. (1994) that investors are overly optimistic about tbe future earnings prospects of “growth” or “glamour” stocks, bid their prices up, and that these stocks’ prices subsequently fall when investors correct their over-optimism.

References

Barth, M. E., J.A. Elliott, and M. W. Finn. 1999. Market rewards associated with patterns of increasing earnings. Journal of Accounting Research 37 (Autumn): 387-413.

Lakonishok, J., A. Shleifer, and R. Vishny. 1994. Contrarian investment, extrapolation, and risk. Journal of Finance 49: 1541-1578.

Skinner, D.J. and R. G. Sloan. 2000. Earnings surprises, growth expectations, and stock returns, or: Don’t let an earnings torpedo sink your portfolio. Working paper. University of Michigan. [Later published in Review of Accounting Studies 7:2 (2002), pp. 289-312]

The improbabilities of companies consistently meeting or exceeding benchmarks, based on the predictions of analysts. Leading to reasonable inference of earnings management, depending on how defined.

Perhaps a circle. Investors expect benchmarks to be met or exceeded, because the analysts predicted a certain result. The more analysts involved, the potentially greater strength of the collective prediction, leading to greater investor expectations that the benchmark will be met or exceeded. All part of an understood circle. A premium paid for shares of companies that regularly meet or exceed benchmarks, though there is a larger proportionate decline in share value, if the benchmark is not met. Investors treating failing to meet a benchmark as more significant than meeting or exceeding a benchmark. Sometimes interpreted to mean that investors have a tendency to exaggerate the extent and duration of negatives.

Perhaps doesn’t have as much to do with numbers or underlying values as it does with investor confidence in management, relative to the messages management is sending. Management would not willingly fail to meet a benchmark and would only accept failure after exhausting all permissible earnings management techniques to meet or exceed such benchmark. If management cannot somehow meet or exceed benchmarks, thus satisfying investor expectations based on analysts’ predictions (and thus completing the circle), there must be something seriously wrong with management judgement or the underlying business variables, or both.

After all, there should be enough of a range within an accounting judgement area to move things to or past a benchmark, more often than not. No?

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About brucelarochelle

Practising Lawyer and Part-Time University Instructor (Accounting, Commercial Law, Organizational Behaviour); Part-Time Federal Tribunal Member. Non-practising Chartered Professional Accountant (Chartered Accountant and Certified Management Accountant).
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