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23-04-2020 | Issue 4/2020

Review of Accounting Studies 4/2020

Economic persistence, earnings informativeness, and stock return regularities

Journal:
Review of Accounting Studies > Issue 4/2020
Authors:
Kai Du, Steven Huddart

Abstract

We propose a simple framework for understanding accounting-based stock return regularities. A firm’s accounting reports provide noisy information about hidden economic states that evolve according to a Markov process. In response to the accounting reports, a representative Bayesian investor forms beliefs about the underlying state and hence the value of the firm. For a population of such firms, the model provides predictions consistent with two sets of well-documented regularities: (i) the market reaction to an earnings announcement that ends a string of consecutive earnings increases and (ii) the return predictabilities based on accruals and book-tax differences. The model also yields novel cross-sectional predictions about the distinct roles of economic persistence and earnings informativeness. We confirm these predictions through empirical tests.

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