Abstract
This study examines whether the presence of patterns in a firm’s earnings history, namely: strings of earnings increases or decreases and breaks in such strings, affects the likelihood and outcomes of management issued guidance. We find that, consistent with increased demand for information about changes in established earnings patterns, firms are more likely to issue guidance before breaks in patterns. For continuing strings, disclosure choices depend on the nature of news: while firms are less likely to issue guidance for strings of decreases, they actively guide for strings of increases after Regulation Fair Disclosure (Reg FD). Our results indicate that management guidance before negative breaks in patterns is incorporated in stock prices upon issuance, and consequently attenuates the market reaction during earnings announcements. However, we fail to find evidence of market reaction to guidance issuances for positive break news, which investors may view as less credible. Overall, we conclude that while firms appear to issue guidance strategically, investors do not fully incorporate the information from management in stock prices. Our findings are consistent with the litigation hypothesis of greater disclosure to avoid litigation risk associated with changes in earnings patterns, and only partially support the claim that management guidance may reduce information asymmetry associated with break events.
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Notes
CEOs like Jamie Dimon of JP Morgan and Larry Fink of BlackRock have gone as far as to argue that companies should not feel obligated to offer guidance (Foley 2016).
Following prior literature, we define earnings strings using changes in seasonally-adjusted quarterly diluted EPS.
For example, trading on management guidance issues by firms with earnings patterns can yield profits to investors, as illustrated by a potential trading strategy in our analysis. In addition, guidance may lower volatility of stock prices around earnings pattern changes since financial disclosures contain information about expected crash risk (Safdar et al. 2022).
The FASB commissioned a two-year project by a Steering Committee, which released a report in January 2001 titled “Improving business reporting: Insights into enhancing voluntary disclosures.” More recently, effective February 2021, the SEC adopted amendments to MD&A disclosure requirements (Item 303) under Regulation S-K to permit investors to see a company “through the eyes of management” and encouraged companies to disclose information regarding known trends or uncertainties.
The overall impact of the regulations is still subject to debate, however there is some evidence of effectiveness of regulatory changes on disclosure. For example, implementation of Regulation G in 2003, which requires reconciliation of managers’ beliefs about core earnings – “non-GAAP earnings” – to their GAAP counterparts, lead to increased transparency and better firm information environment (Chen et al. 2022a, b).
In additional untabulated analysis we compare the content of management guidance across different types of firm observations: strings, breaks and no pattern. We find that guidance news, relative to analysts’ forecasts are consistent with the earnings change sign. Guidance contains higher proportion of negative news for decreases in earnings than for earnings increases, and more positive news for increases in earnings than for earnings decreases across all types of firms.
Our results for negative breaks in 1993–2000 sub-period are opposite to our main findings. Here, negative coefficient on the interaction term Break#EIndex indicates that lower (better) governance quality firms that experience a break are less (more) likely to issue guidance, indicating that governance played a different role in disclosure of negative breaks before the regulatory changes.
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Acknowlegements
We wish to thank Cheng Few Lee (the editor), two anonymous referees, Tunde Odusami and participants of the 2022 Eastern Finance Association meeting for their valuable comment. Any errors are our responsibility.
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Appendices
Appendix 1
This appendix presents examples of String, Break and No Pattern Firms. Examples are randomly selected from our sample for the period 1999–2002 (before and after RegFD) and provided for illustration purposes only. All changes in earnings are seasonally- and split-adjusted and based on diluted EPS before extraordinary items.
Company name (Ticker) | Industry | Data Date | Quarterly results | Classification |
|---|---|---|---|---|
Northwest pipe company (NASDAQ: NWPX) | Construction engineering | 31MAR2001 | The company reported 5th consecutive decrease in EPS | STRING DOWN |
Schlumberger Ltd (NYSE: SLB) | Oilfield services | 31DEC2000 | The company reported 4th consecutive increase in EPS | STRING UP |
Pomeroy computer resources, Inc. (NASDAQ: PMRY) | Computer software | 31DEC1999 | The company reported 11th consecutive increase in EPS | STRING UP |
Polycom, Inc (NASDAQ: PLCM) | Telecommunications | 30JUN2000 | The company reported a decrease in EPS, following a series of nine consecutive earnings increases | BREAK DOWN |
Parker drilling company (OTCMKTS: PKDC) | Oil industry | 30JUN2000 | The company reported an increase in EPS, following a series of six consecutive earnings decreases | BREAK UP |
Qualcomm, Inc (NASDAQ: QCOM) | Semiconductors | 31MAR2002 | The company reported a decrease in EPS, following a decrease in the preceding quarter and an increase in two quarters prior | NO PATTERN DOWN |
Schuler homes, Inc. (NASDAQ: SHLR) | Home construction | 31DEC2000 | The company reported an increase in EPS, following a decrease in the preceding quarter, which was not classified as part of a string | NO PATTERN UP |
Appendix 2
Variable name | Description |
|---|---|
Guide | Indicator variable that is equal to 1 if the firm issues guidance for the quarter and 0 otherwise |
Precision | The precision of company issued guidance, equals three if a point estimate, two if a range estimate, and one if an open interval |
Duration | Days between guidance issue and earnings announcement |
Guidance CAR | Cumulative abnormal return over ( − 1, + 1) days around guidance issue |
Break | Indicator variable that is equal to 1 if the quarter is a break quarter and 0 otherwise |
String | Indicator variable that is equal to 1 if the quarter is part of the earnings string and 0 otherwise |
EGrowth | % growth in seasonally-adjusted earnings, which equals ∆E/|E t-4|, where ∆E = E t—Et-4 |
AFE | Consensus analysts’ forecast error calculated as I/B/E/S actual earnings minus most recent median consensus forecast |
Analysts | Log (1 + number of analysts following) |
Inst | Institutional holdings as a % of total shares outstanding |
∆Inst | Quarterly change in institutional holdings scaled by shares outstanding |
Mngt | Stock holdings by management, calculated as the sum of shares owned by management over the total shares outstanding |
Age | Age of the firm in years (since its appearance in CRSP database) |
MV | Market value of the firm ($ millions) |
BM | Book-to-market ratio |
Beta | Beta of the firm estimated from the market model over the period ( − 255, − 46) days before the earnings announcement |
IVol | Proxy of firm-specific risk, measured as standard deviation of residuals from market model estimation, i.e., idiosyncratic volatility |
STurnover | Stock liquidity proxy, measured as a share turnover ratio |
Litigation | Litigation variable that is set equal to 1 if the firm is a member of one of high-litigation-risk industries: biotechnology (SIC codes 2833–2836, SIC codes 8731–8734), computer (SIC codes 3570–3577, SIC codes 7370–7374), electronics (SIC codes 3600–3674), and retail (SIC codes 5200–5961) industries |
BMDisp | The industry book-to-market ratio dispersion calculated based on a two digit SIC code |
EIndex | The count of 6 provisions from the corporate documents as in Bebchuk et al. (2009) so that 0 represents the highest and 6 the lowest quality of corporate governance |
IndDirectors | The proportion of independent directors on the board of directors |
EquityComp | A proportion of compensation excluding salary and bonus relative to total compensation |
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Agapova, A., Aier, J.K. & DeVides, Z. Earnings patterns and managerial guidance. Rev Quant Finan Acc 59, 1173–1213 (2022). https://doi.org/10.1007/s11156-022-01073-9
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DOI: https://doi.org/10.1007/s11156-022-01073-9