Earnings Increases as a Type-Revealing Signal

54 Pages Posted: 28 Jan 2016 Last revised: 26 Feb 2016

See all articles by Messod Daniel Beneish

Messod Daniel Beneish

Indiana University - Kelley School of Business - Department of Accounting

Vedran Capkun

HEC Paris - Accounting and Management Control Department

Date Written: January 5, 2016

Abstract

While increases in earnings are common, we identify a setting in which they signal a separating equilibrium. Firms that “defy gravity’ (DG) by reporting increases in earnings despite experiencing a decline in sales from continuing operations, signal their viability as a going- concern, and achieve separation from other firms with decreasing sales. We find that DG signals higher future earnings, cash flows, and one-year-ahead stock returns. More importantly, we find that the DG signal is more credible when more costly to produce: DG firms subsequently perform better when (1) they are ex ante in poorer financial health, (2) the magnitude of the earnings shortfall is larger (they have higher downward cost rigidity), (3) they pass up the opportunity of taking a ‘big bath’ in times of crisis (years where declines in earnings can be blamed on economy-wide shocks), and (4) when they have less flexibility to manage earnings upwards. Finally, because some degree of pooling remains within DG firms, we show that the DG signal is more credible when it is produced contemporaneously with abnormal CEO buying. To our knowledge, this study is the first to provide empirical evidence that earnings increases that are more costly to achieve are more credible signals of future performance.

Keywords: Signaling, Costliness, Credibility, Earnings

JEL Classification: G14, G17, M4

Suggested Citation

Beneish, Messod Daniel and Capkun, Vedran, Earnings Increases as a Type-Revealing Signal (January 5, 2016). Kelley School of Business Research Paper No. 16-10; HEC Paris Research Paper No. ACC-2016-1132. Available at SSRN: https://ssrn.com/abstract=2723386 or http://dx.doi.org/10.2139/ssrn.2723386

Messod Daniel Beneish (Contact Author)

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
812-855-2628 (Phone)
812-855-4985 (Fax)

Vedran Capkun

HEC Paris - Accounting and Management Control Department ( email )

Jouy-en-Josas Cedex
France

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