Earnings Forecast, Earnings Management, and Asymmetric Price Response

Abstract

The empirical evidence on earnings management and the corresponding stock price response to earnings announcements has consistently uncovered two important regularities: Missing an earnings target triggers a large and disproportionate negative stock price response, while exceeding such a target meets with only a moderate increase in stock price; and firms seem to manipulate their announced earnings to meet/beat earnings targets. I seek a rational explanation that connects these regularities by formulating an analytical model of earnings forecasts, mandatory earnings announcements and stock price behavior. I show that there is a kink in the distribution of reported earnings located close to but to the left of the earnings forecast. I also show that the equilibrium stock price schedule is much steeper when reported earnings lie below the forecast than when reported earnings lie above the forecast. These results help shed light on many puzzling empirical findings.

Keywords: Earnings Management, Asymmetric Price Reponse

JEL Classification: M41, M43, M45, G14