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Review of Quantitative Finance and Accounting

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01.05.2014 | Original Research

Measuring investors’ assessment of earnings persistence: do investors see through smoothed earnings?

verfasst von: Zheng Wang

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2014

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Abstract

Prior studies document that investors value persistent earnings more than transitory earnings. This argument offers incentives to managers to smooth their reported earnings and make them look more persistent. This study examines whether investors are misled by management’s income-smoothing behavior and whether they can correctly assess the persistence of smoothed earnings. Using a simple theoretical model, this paper shows that investors’ assessment of earnings persistence can be derived from their reactions to reported earnings, which is the ratio of the coefficient on earnings change relative to the coefficient on earnings level in the return–earnings relation. Empirical results show that investors’ assessment of earnings persistence is negatively associated with the level of income smoothing after controlling for time-series persistence of earnings and hence suggest that investors understand that the high persistence of smoothed earnings is not real and they discount the persistence of smoothed earnings when they react to such earnings news.

Vorheriger Artikel A reduced lattice model for option pricing under regime-switching

Nächster Artikel Financial and monetary policy responses to oil price shocks: evidence from oil-importing and oil-exporting countries

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Many studies include earnings persistence as a control variable when examine earnings response coefficients and confirm that earnings persistence increases market reactions to earnings (Park and Pincus 2001; Lim and Tan 2007).

An AR(1) process is defined as \( x_{t} = \theta x_{t - 1} + \eta_{t} \), where \( \eta_{t} \) is the unexpected earnings in period t.

For simplicity, I assume that the first period earnings, \( x_{1} \), is equal to the earnings innovation, \( \eta_{1} \). The results will not be changed if \( x_{1} \) is assumed to be equal to an expected value \( \overline{x} \) plus \( \eta_{1} \).

The variance of \( \eta_{4} \) is assumed to be different from those of \( \eta_{1} \), \( \eta_{2} \), and \( \eta_{3} \) because \( X_{4} \) is a weighted average of all future earnings from period 4 and beyond.

Detailed calculation procedures of the coefficient estimators are provided in “Appendix”.

Following Tucker and Zarowin (2006), accruals are defined as net income minus cash flows from operation. The tests were also redone using net income minus total cash flows, with similar results.

0.207/(0.416 + 0.328) ≈ 28 %.

0.200/(0.334 + 0.248) ≈ 34 %.

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Titel: Measuring investors’ assessment of earnings persistence: do investors see through smoothed earnings?
verfasst von: Zheng Wang
Publikationsdatum: 01.05.2014
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2014
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-013-0358-8

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