Accounting and Finance 49 (2009) 223246

ORIGINAL A. S. Ahmed et ARTICLE al./Accounting al. and Finance XX (2008) XXXXXX Blackwell Oxford, Accounting ACFI 1467-629X 0810-5391 Journal XXX The Authors compilation UK Publishing and Finance Ltd 2008 AFAANZ

Earnings characteristics and analysts differential interpretation of earnings announcements: An empirical analysis
Anwer S. Ahmeda, Minsup Songb, Douglas E. Stevensc

a Mays Business School, Texas A&M University, College Station, 77843-4113, USA College of Business Administration, Sogang University, Seoul, 121-742, South Korea c College of Business, Florida State University, Tallahassee, 32306-1110, USA

Abstract This study provides empirical evidence on factors that drive differential interpretation of earnings announcements. We document that Kandel and Pearsons forecast measures of differential interpretation are decreasing in proxies for earnings quality and pre-announcement information quality. This evidence yields new and useful insights regarding which earnings announcements are less likely to generate newfound disagreement among analysts and investors. Recent research suggests that investor disagreement can increase investment risk, increase the cost of capital, and cause stock prices to deviate from fundamental value. Therefore, our results support prior intuition that increasing the quality of earnings and preannouncement information can improve the efciency of capital markets. Key words: Differential interpretation; Earnings announcements; Analyst forecasts JEL classication: G14, M41 doi: 10.1111/j.1467-629X.2008.00292.x

1. Introduction Researchers have long recognized the potential for public announcements to be differentially interpreted by market participants (Bachelier, 1900). However,
We thank Orie Barron, David Harris, Gerry Lobo, Stan Markov, Yongtae Kim and Senyo Tse; workshop participants at Concordia University, University of Idaho, Seongkyunkwan University, Syracuse University, Wilfried Laurier University and York University; and participants at the 2006 American Accounting Association Annual Meeting for their helpful comments. This study is based on Professor Songs dissertation at Syracuse University. We thank Thomson Financial I/B/E/S for providing data on analysts earnings forecasts. Received 26 June 2008; accepted 8 November 2008 by Robert Faff (Editor).

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it is only recently that researchers have provided empirical evidence of this differential interpretation (see e.g. Kandel and Pearson, 1995; Bamber et al., 1999). However, to date, the driving factors behind differential interpretation remain unknown. We address this gap in the literature by empirically investigating factors that are likely to drive the differential interpretation of earnings announcements. To develop potential determinants of differential interpretation, we use intuition from the rational expectations model of Kim and Verrecchia (1994). Rational expectations models characterize investor information as comprised of public and private information signals that are normally distributed with mean and precision (reciprocal of variance).1 In these models, precision captures the quality or informedness of the information signal (Verrecchia, 2001). Kim and Verrecchias (1994) model suggests that differential interpretation of an earnings announcement is decreasing in: (i) the precision of the earnings announcement; (ii) the precision of pre-announcement information; and (iii) the cost of acquiring private information. Intuitively, these three information constructs reduce differential interpretation by reducing the return to acquiring private information to interpret the earnings idiosyncratically. Therefore, we select earnings and rm characteristics that are likely to proxy for these information constructs. In particular, we use earnings predictability, earnings persistence, earnings surprise and negative earnings to proxy for the precision of the earnings announcement. We use rm size to proxy for the quality of pre-announcement information and, controlling for rm size, use analyst coverage and price-to-book ratio to proxy for the cost of acquiring private information.2 Following Kandel and Pearson (1995), we measure differential interpretation by comparing pairs of analysts forecast revisions of annual earnings around the preceding quarterly earnings announcements. Financial analysts represent an important group of market agents who are motivated to take full account of others information and acquire private information where it is protable (Kandel and Pearson, 1995, p. 833). Therefore, their forecasts of earnings provide an ideal dataset by which to examine factors driving differential interpretation of earnings announcements. Kandel and Pearson (1995) present a model of Bayesian updating with two agents who observe a public announcement. They show that if two traders have identical likelihoods regarding the public announcement,

Rational expectations models assume that investor expectations are conditional on the precision of their information and the price at which markets clear (Verrecchia, 2001). We argue that with rm size in the model, analyst coverage and the price-to-book ratio are likely to capture the cost of private information acquisition in Kim and Verrecchias (1994) model. In particular, we argue that after controlling for rm size, analyst coverage is likely to capture the return to private information acquisition and the price-tobook ratio is likely to capture the difculty of valuing a rm with high intangible assets (see Section 2.2).

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their mean beliefs will never ip or diverge if they move in different directions as a result of the announcement. Upon nding a relatively high proportion of forecast pairs that exhibit these patterns around quarterly earnings announcements, Kandel and Pearson (1995) conclude that earnings announcements are differentially interpreted. Using logistic regression models and analyst forecast data from 19832004 inclusive, we examine the proportion of analyst forecast revision pairs exhibiting Kandel and Pearsons differential interpretation patterns around quarterly earnings announcements. We nd that Kandel and Pearsons forecast measures for differential interpretation are: (i) negatively related to earnings predictability, rm size and price-to-book ratio, and (ii) positively related to earnings surprise, negative earnings and analyst coverage. Our ndings support Kim and Verrecchias (1994) intuition that differential interpretation is decreasing in earnings quality, pre-announcement information quality, and the cost of acquiring private information. This evidence yields new and useful insights. Theoretical and empirical research suggests that investor disagreement caused by information asymmetry can increase investment risk and, thereby, increase a rms cost of capital (Kim and Verrecchia, 1994, 1997; Verrecchia, 2001; Botosan et al., 2004).3 In addition, research suggests that differences in investors beliefs, together with short selling constraints, can cause stock prices to deviate from their fundamental value (Miller, 1977; Harrison and Kreps, 1978) and potentially form market bubbles (Scheinkman and Wei, 2003; Hong et al., 2006). The conventional wisdom has been that earnings announcements reduce information asymmetry by substituting a public announcement for private pre-announcement information.4 However, empirical evidence suggests that some earnings announcements generate newfound disagreement by generating additional private information gathering (Kandel and Pearson, 1995; Bamber et al., 1999). We extend this line of research by documenting which earnings announcements are less likely to generate newfound disagreement. Our results support prior intuition that increasing the quality of earnings and pre-announcement information can improve the efciency of capital markets.

Conceptually, the cost of capital increases when some subset of investors gain an informational advantage over other investors and those with inferior information face an adverseselection problem (Kim and Verrecchia, 1994, 1997; Verrecchia, 2001). Empirical evidence in Botosan et al. (2004) supports this positive relation between information asymmetry and a rms cost of capital.

Penman (2004, 77) writes, Bubbles work like a pyramiding chain letter. Speculative beliefs feed rising stock prices that beget even higher prices, spurred on by further speculation. Momentum investing displaces fundamental investing, promoting the rise in prices. The role of accounting is to cut the chain letter, to challenge speculative beliefs, and so anchor investors.

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The remainder of the present paper is organized as follows. In the following section, we identify potential determinants of differential interpretation and relate them to earnings and rm characteristics. In Section 3, we describe our sample and explain the Kandel and Pearson (1995) measures of differential interpretation. In Section 4, we present our empirical results and, in Section 5, we conduct sensitivity tests. We conclude in Section 6 by discussing the implications of our results. 2. Determinants of differential interpretation and choice of proxies Theorists have modelled differential interpretation of a public announcement in various ways. In Kandel and Pearsons (1995) model of Bayesian updating, agents interpret the announcement differently because they possess different likelihoods regarding the mean error in the announcement. In Kim and Verrecchias (1994) rational expectations model, agents interpret the announcement differently because they acquire private information about the precision of the announcement. Both models capture the intuition that agents apply differential knowledge or expertise when processing a public announcement. However, in Kandel and Pearsons model, the source of differential interpretation (differential likelihoods) is exogenous, whereas the source of differential interpretation in Kim and Verrecchias model (private information) is endogenously determined. Therefore, we rely on Kim and Verrecchias model to identify potential determinants of differential interpretation and empirical proxies. Similar to Kim and Verrecchia (1994), we assume that differential interpretation of an earnings announcement arises when investors (or analysts) acquire private information regarding the precision of the earnings announcement. In their model, Kim and Verrecchia show that the number of agents who acquire private information leading to differential interpretation of an earnings announcement is decreasing in: (i) the precision of the earnings announcement; (ii) the precision of pre-announcement information; and (iii) the cost of acquiring the private information (see Lemma 1). Intuitively, the more precise the earnings announcement or pre-announcement information, the lower the advantage of interpreting the earnings idiosyncratically (becoming an information processor). That is, the quality of publicly available information reduces the net benet from acquiring private information to differentially interpret the earnings. Similarly, the cost of acquiring the private information reduces differential interpretation by reducing the net benet of differential information processing. We select empirical proxies that are likely to capture the determinants of differential interpretation suggested by Kim and Verrecchia (1994). In particular, we examine the effect of eight variables on differential interpretation of earnings announcements: four variables related to earnings characteristics and four variables related to rm characteristics. The four earnings variables we examine include earnings predictability, earnings persistence, earnings surprise and negative earnings. The four rm variables we examine include rm size, analyst coverage, The Authors

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volatility of operating cash ows and price-to-book ratio. Below we describe these variables and present intuition regarding their potential effect on differential interpretation. 2.1. Earnings characteristics We examine four earnings variables that are likely to reect the precision or quality of the earnings announcement. First, more predictable earnings tell us more about future earnings and thereby have a greater impact on stock price than less predictable earnings (Lipe, 1990). Because one of analysts main concerns is to make accurate forecasts of earnings (Mikhail et al., 1997; Hong et al., 2000; Hong and Kubik, 2003; Penman, 2004), analysts are more likely to rely on accounting earnings with high predictability than on earnings with low predictability (Lee, 1999). In particular, analysts are less likely to acquire private information to differentially interpret the earnings when such earnings contain high predictability. Therefore, we expect a negative relation between earnings predictability and differential interpretation. Second, earnings with higher persistence are regarded as having higher quality. This is because persistent earnings are sustainable (i.e. they are more likely to recur in the future). Persistent earnings are also regarded as a desirable attribute by analysts (Francis et al., 2004) and have a greater impact than earnings that are transitory (Lipe, 1990). Therefore, as with predictability, analysts are more likely to rely on accounting earnings with high persistence than on earnings with low persistence. In particular, analysts are less likely to acquire private information to differentially interpret the earnings when such earnings contain high persistence. Therefore, we expect a negative relation between earnings persistence and differential interpretation. Third, earnings surprise captures the average inaccuracy of analysts prior belief about the earnings announcement. The larger the surprise in the earnings, the more uncertainty there is likely to be about its implications for future earnings. Brown and Han (1992) nd that earnings announcements with large magnitudes of earnings surprise decrease the convergence of analysts forecasts about future earnings. Furthermore, Freeman and Tse (1992) provide evidence that the marginal response of stock price to unexpected earnings (Earnings Response Coefcient) declines as the absolute magnitude of unexpected earnings increases. This non-linear relationship rests on the premise that the magnitude of unexpected earnings is negatively correlated with earnings persistence. Hence, we expect a positive relation between the magnitude of earnings surprise and differential interpretation. Finally, losses are less informative about a rms future prospects than prots. This is because of the liquidation option (Stickel, 1990; Hayn, 1995), conservatism (Klein and Marquardt, 2006) and the tendency for rms to load up negative accruals in a down year and take a bath (Penman, 2004). Therefore, losses are likely to be temporary and exhibit low persistence. Hence, similar to The Authors

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large magnitudes of earnings surprise, we expect there to be greater differential interpretation when a rm announces losses than when it announces prots. 2.2. Firm characteristics We examine four rm characteristics that are likely to reect pre-announcement information quality as well as the complexity of a rms business. First, rm size is widely cited as a proxy for the richness of a rms information environment (Atiase, 1985; Bhushan, 1989; Brennan and Hughes, 1991). In addition, larger rms tend to have better disclosure policies (Lang and Lundholm, 1993, 1996). Therefore, holding other things constant, analysts have less incentive to acquire private information to differentially interpret the earnings of large rms. Therefore, we expect there to be less differential interpretation for large rms relative to small rms. Second, analyst coverage is another widely used proxy for the information environment of the rm. Although analyst coverage reects an increase in the amount of information available to investors (Shores, 1990; Stickel, 1990; Lang and Lundholm, 1993), analyst coverage also reects the number of informed traders in the market (Brennan et al., 1993; Brennan and Subrahmanyam, 1995). Furthermore, nancial analysts are motivated to take full account of others information and acquire private information where it is protable (Kandel and Pearson, 1995). Therefore, after controlling for rm size, we expect a positive relation between analyst coverage and differential interpretation. Third, we use the volatility of operating cash ows as a measure of underlying operational uncertainty. The operating cash ows number is less subject to management discretion than earnings (Sloan, 1996; Dechow et al., 1998), and the volatility of operating cash ows is therefore more likely to reect uncertainty in the underlying business operation. Another result in Kim and Verrecchia (1994) is that increased uncertainty in the cash ows of the rm (for which earnings is a predictor) leads to more private information processing leading to differential interpretation of earnings. Because uncertainty in the cash ows of the rm adds to the underlying uncertainty of the earnings signal, this result is consistent with their result that less precise earnings leads to more private information processing. Therefore, holding other things constant, we expect a positive relation between the volatility of operating cash ows and differential interpretation. Finally, rms that have higher intangible assets are likely to be more difcult to value and analyse all else held constant (Barth et al. 2001). This implies that the cost of acquiring private information for these rms is likely to be high relative to rms with low intangible assets. Firms with higher intangible assets may also operate in an environment where there is greater operational uncertainty or higher benet (return) to private information acquisition. However, with volatility of operating cash ows and analyst following in the model, we expect the effect of the higher cost of acquiring private information to dominate The Authors

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these alternative effects. Using the price-to-book ratio as a measure of intangible assets (Fama and French, 1995), we therefore expect a negative relation between the price-to-book ratio and the acquisition of private information leading to differential interpretation. 3. Sample, data and variable measurement 3.1. Sample selection The sample consists of rm-year observations between 1983 and 2004, inclusive, meeting the following data requirements:5 1 The quarterly earnings announcement date is available on the quarterly Compustat les or Institutional Brokers Estimate System (I/B/E/S) Actual les.6 2 Earnings, assets and other nancial statement data are available on Compustat over the 10 years preceding the year of the earnings announcement. 3 Analysts forecasts of annual and quarterly earnings and actual earnings data are available on the I/B/E/S Detailed and Actual les. To be included in the sample, an analyst must issue forecasts of annual earnings within both pre- and post-announcement periods.7 We examine individual analysts 1 year ahead earnings forecast revisions around quarterly earnings announcements.8 To avoid the problem of stale forecasts (Barron, 1995), we limit individual analyst forecasts from I/B/E/S Detailed les to those issued immediately before and after the earnings announcement. Panel A of Table 1 shows three windows that we use to examine forecast revisions around quarterly earnings announcements. In Window 1, we dene the pre-announcement period as 15 days to 1 day prior to the quarterly earnings announcement, and the post-announcement period as the earnings announcement date to 14 days after the announcement. In Window 2, we increase the pre-announcement period to 30 days before the quarterly earnings announcement date because analysts are less likely to issue their forecasts in the 2 weeks before the earnings announcement (Stickel, 1989; Ivkovi and Jegadeesh, 2004). In Window 3, we increase the pre-announcement period further to 42 days before the announcement and increase the post-announcement
5

From the year 1983 onward, signicantly large numbers of individual analyst forecast data are available in the I/B/E/S Detail Tape.

If the Compustat earnings announcement date is not available, the I/B/E/S earnings announcement date is used.
7 In rare cases in which multiple forecasts are available from the same individual analyst within a pre- or post-announcement period, we use the forecast closest to the earnings announcement date. 8

For the analyst forecast revision around quarter 4 earnings announcements, we use changes in the 2 year ahead earnings forecast.

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Table 1 Time windows and descriptive information on rm observations Panel A: Time windows used to examine forecast revisions around quarterly earnings announcements Announcement samples Windows 1 2 3 Pre-announcement period days 15 to 1 days 30 to 1 days 42 to 1 Post-announcement period days 0 to 14 days 0 to 14 days 0 to 30

Panel B: Descriptive information on rm observations by year and time window Window 1 Number of rm observations 45 100 69 72 119 155 183 258 237 210 255 304 377 397 459 490 426 648 766 878 1 069 785 8 302 377 Window 2 Number of rm observations 131 298 204 198 278 328 438 577 579 473 599 712 786 834 994 1 016 877 1 309 1 443 1 565 1 859 1 294 16 792 763 Window 3 Number of rm observations 522 923 788 859 960 957 1 087 1 207 1 226 942 1 138 1 243 1 334 1 370 1 549 1 503 1 289 1 720 1 885 2 027 2 379 1 668 28 576 1 299

Year 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Total Mean

Number of rms 45 89 63 65 97 121 144 178 165 171 189 219 236 271 310 324 291 397 453 505 591 523 5 447 248

Number of rms 112 217 159 157 184 219 277 326 326 304 350 406 432 460 531 532 505 673 714 764 881 796 9 325 424

Number of rms 333 477 444 454 487 478 522 554 577 517 559 613 646 668 734 716 676 796 852 904 1 059 982 14 048 639

period to 30 days after the announcement. This window is widely used by previous empirical studies that examine analyst forecast revisions (e.g. Barron, 1995; Bamber et al., 1999; Barron et al., 2002). Panel B of Table 1 presents the number of sample rms and sample rm observations for each of the three windows in each scal year used in the The Authors

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Figure 1 Forecasts used to capture differential interpretation of quarterly earnings announcements.

study (19832004). Window 1 includes on average 248 rms per year with 377 observations. Increasing the pre- and post-announcement periods increases the average number of rms in our sample to 424 in Window 2 and 639 in Window 3. 3.2. Differential interpretation measures We use empirical proxies for differential interpretation developed by Kandel and Pearson (1995). Kandel and Pearson use the change in forecasts of year t earnings around preceding quarterly q earnings announcements to capture differential interpretation. Figure 1 shows that we use forecasts of annual earnings from the pre-announcement period, Fi,pre q , t , and the post-announcement period, Fi,post , to form our forecast proxies. Following a Bayesian process, two q, t analysts i and j observing the quarterly earnings announcement, yq, update their forecast of annual earnings as follows: Analyst i s revision: Analyst j s revision:
pre Fi,post q , t = (1 i )Fi,q , t + i ( yq + i,q ) pre Fjpost ,q , t = (1 j )Fj,q , t + j ( yq + j,q ),

where i is the analyst-specic weight placed on the prior belief, Fi,pre q , t , in the updating process and i,q reects the analyst-specic error term. Kandel and Pearson (1995) interpret this analyst-specic error term as differential interpretation of the quarterly earnings announcement.9 Kandel and Pearson (1995) propose that if the error term of the quarterly earnings signal yq is common to all analysts that is, i,q = j,q = q the following restrictions
9

Similar intuition is found in the models of Kim and Verrecchia (1994, 1997), where a private signal is available that can only be used in combination with the earnings signal. The key characteristic of this private signal is that it provides a unique context or interpretation to the earnings announcement.

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must be satised: (i) the distance between two analysts posterior beliefs pre post post cannot exceed that between their priors (i.e. | Fi,pre q , t Fj,q , t | | Fi,q , t Fj,q , t | ); and pre (ii) the relative pessimist cannot turn into the optimist (i.e. if Fi,q, t > Fjpre ,q , t , then post Fi,post > F ). Therefore, analyst forecast pairs that either diverge or ip after a q, t j,q , t quarterly earnings announcement are possible if and only if the error terms are different across the analysts (i,q j,q). Therefore, forecast pairs that exhibit the behaviour in Case (i) and Case (ii) demonstrate differential interpretation of the quarterly earnings announcement. Following Kandel and Pearson (1995), we measure differential interpretation of an earnings announcement by comparing pairs of analysts forecast revisions of year t annual earnings around the preceding quarterly q earnings announcements. Specically, for analyst pairs whose forecast revisions move in opposite directions, a Flip or a Divergence case is recognized when a pair of analyst forecasts shows the revision pattern of Case (i) or Case (ii), respectively. Finally, an Inconsistence case is recognized when the two forecasts exhibit either a Flip or Divergence. For each earnings announcement, the proportion of Flips, Divergences and Inconsistencies serve as our dependent variables capturing differential interpretation. 3.3. Measurements of earnings and rm characteristics Following Lipe (1990), we measure the predictability and persistence of earnings using forecast errors from a time-series model. More specically, we measure earnings predictability as the standard deviation of forecast errors from an autoregressive model of order one (AR1) for annual earnings before extraordinary items scaled by average assets: yt = 0 + 1yt1 + t. For each rm in year t, we estimate equation (1) using ordinary least-squares regression and rolling 10 year windows.10 Predictability (Predict) is measured by the standard deviation of the errors () from the AR1 model. We multiply the standard deviation by negative one (1) so that a higher value of this measure reects higher earnings predictability. Our measure of persistence (Persist) is also derived from the rmspecic value of 1 from the above AR1 model.11 The magnitude of earnings surprise is the absolute value of mean forecast error using forecasts of quarterly earnings issued within 45 days before the quarter q earnings announcement. Following previous studies (e.g. Lang and Lundholm, 1993, 1996), we deate absolute mean forecast error by the scal quarter q ending stock price. The negative earnings dummy variable (NegEPS) is determined by the sign of earnings per share reported in the I/B/E/S Actual le.

10 11

We require a minimum of eight observations in 10 years.

In sensitivity tests, we also use higher order time series models, such as the IMA (1, 0), ARIMA (1, 1, 0) and ARIMA (2, 1, 0), and achieve similar results.

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The volatility of cash ows is captured by the standard deviation of operating cash ows over the preceding 10 years (StdCash).12 Because cash ow information from the statement of cash ows is only available after the Statement of Financial Accounting Standards No. 95 effective in 1987, we measure cash ows from nancial information in the balance sheet following Sloan (1996). Firm size is measured by the log of the market value of equity (lnMV) at each quarter q ending date, and the analyst coverage variable (Coverage) is measured by the log of the number of analysts following the rm in a given year. The priceto-book ratio (P/B) is measured by the total market value of equity divided by total stockholders equity at the end of each quarter q. Finally, we include the change in aggregate analyst beliefs as a control variable. Kandel and Pearson (1995) emphasize that their proxy measures are likely to understate differential interpretation under large earnings surprises because analysts are more likely to revise their forecasts in the same direction.13 Similarly, Bamber et al. (1999) argue that the greater the change in aggregate beliefs, the greater the measurement error in the Kandel and Pearson (1995) proxies for differential interpretation. Following Bamber et al., we control for this potential measurement error by including the absolute mean forecast revision, AbsRev, in the model. Consistent with other variables, we deate AbsRev by quarter-end stock price. In all regression models, we also include dummy variables of scal quarters and scal years to control for potential unknown effects. 3.4. Logit regression model Our dependent variable has a binary form, which is equal to 1 if the pair exhibits a pattern of Kandel and Pearson (1995) differential revision, and 0 otherwise. Because all pairs of forecast revisions issued by analysts following the same rm have the same independent variables, our dependent variables form grouped binary response data. In this grouped data setting, proportional dependent variables are often used in the logistic (or Poisson) regression model to investigate the relationship between these discrete responses and a set of explanatory variables (Greene, 1999). In our tests, we use the proportions of differential revisions showing a Flip, Divergence and Inconsistence pattern as the dependent variables in our logit regression model. Because we do not know the particular relation between the dependent and independent variables, we present our regression results in steps. In the rst regression model, we examine the relation between the Kandel and Pearson (1995) measures and the earnings-related variables. In the second regression

12 13

We require a minimum of eight observations in 10 years.

This measurement error will result in downward-biased estimates of the proportions of pairwise inconsistencies due to differential interpretation, which will reduce the power of our tests.

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model, we examine the relation between the Kandel and Pearson (1995) measures and the rm-related variables. In the third regression model, we include all of the independent variables to examine the incremental effects of each variable. 4. Empirical results 4.1 Descriptive statistics and simple correlations Table 2 presents the average proportion of the Kandel and Pearson (1995) differential interpretation measures for each of our three time windows. We multiply each Kandel and Pearson measure by 100 for the purposes of this table. The average proportion of Flips and Divergences are 8.88 and 7.98 per cent in Window 1 and 8.82 and 7.94 per cent in Window 2, respectively. In Window 3, the proportions increase to 9.73 and 8.83 per cent, respectively. These numbers are comparable to those of Kandel and Pearson (1995) over a similar time window (9.24 and 11.39 per cent, respectively, in Window 3). The average proportion of Inconsistencies range from 13.51 per cent in Window 1 to 14.75 per cent in Window 3. The value of Inconsistencies is not equal to the sum of Flips and Divergences because a single observation might be both a Flip
Table 2 Descriptive statistics of frequencies of Flips, Divergences and Inconsistencies The proportion of differential revision pairs Flips Window 1 (15, +14)a Mean N Window 2 (30, +14) Mean N Window 3 (42, +30) Mean N
a

Divergences

Inconsistencies

8.88 8 302 8.82 16 792 9.73 28 576

7.98 8 302 7.94 16 792 8.83 28 576

13.51 8 302 13.42 16 792 14.75 28 576

See Table 1 for the denition of pre- and post-announcement periods for each Window. Flips is the proportion of analyst pairs that move in opposite directions and ip. A Flip = 1 if
post pre post pre pre post post pre pre sign( Fi,pre q, t F i,q, t ) sign( Fj ,q, t Fj ,q, t ), F i,q, t > Fj ,q, t and F i,q, t < Fj ,q, t for two analysts i j and F i,q, t > Fj ,q, t ,

where for a given quarter q earnings announcement in scal year t + 1, Fi,pre q, t = analyst is year t annual earnings announcement in quarter q pre-announcement (if superscript = pre) or post-announcement (if superscript = post). Divergences is the proportion of analyst pairs that move in opposite directions and diverge. A Divergence = 1 if
post pre post pre pre post post sign( Fi,pre q, t F i,q, t ) sign( Fj ,q, t Fj ,q, t ), | F i,q, t Fj ,q, t | < | F i,q, t Fj ,q, t | ;

Inconsistencies is the proportion of analyst pairs that move in opposite directions and either ip or diverge.

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and a Divergence (i.e. a forecast pair that moves in opposite directions might both ip and end up further apart). In the tables below, we present results using Window 3 forecast revisions. Our inferences are unchanged when we use either of the shorter time windows. Panel A of Table 3 reports summary statistics on earnings characteristics, rm characteristics and the control variables we use in our analysis. The mean (median) value of earnings predictability, Predict, is 0.0467 (0.0285). Note that we use the negative value of the standard deviation of errors from an AR(1) model to facilitate the interpretation of our results. The mean (median) value of earnings persistence, Persist, is 0.3929 (0.4129) and the mean (median) value of the absolute forecast error, AbsFE, is 0.0058 (0.0013). About 11.34 per cent of our sample observations report negative quarterly EPS (NegEPS) in the I/B/E/S Actual le. The mean (median) value of the standard deviation of annual operating cash ows, StdCash, is 0.0742 (0.0558) and that of the price-to-book ratio, P/B, is 3.64 (2.13). On average, our sample rms are followed by 18.43 analysts (Coverage). The absolute value of mean forecast revision divided by stock price, AbsRev, has a mean (median) value of 0.0076 (0.0029). Not surprisingly, our sample rms are very large, with mean (median) market value of equity, MV, of 8334 (2065) million dollars. This is because of our data requirements of at least 8 years of historical nancial data and at least two analysts who revise their forecasts around the quarterly earnings announcements. Hence, caution is needed in generalizing our empirical results for small rms. Panel B of Table 3 presents simple correlations among our dependent, independent and control variables using Window 3. Following Lang and Lundholm (1996), we use decile-ranked values of the independent variables because we do not predict the particular functional form of the relation between the dependent and independent variables and in order to control for outliers. We rank independent variables from original data within their industry-year and convert the ranks to deciles. Note that our results are robust to using continuous variables. The rst two columns report the correlations among Flips, Divergences and Inconsistencies. As expected, the three measures are highly positively correlated. The next eight columns report correlations between Flips, Divergences and Inconsistencies and the earnings and rm characteristics. Although the simple correlations do not support any of our predictions, they must be interpreted with care because they do not control for other variables in the model. Furthermore, Flips, Divergences and Inconsistencies are all negatively correlated with the absolute mean forecast revision (AbsRev), suggesting that the Kandel and Pearson (1995) measures underestimate the true extent of differential interpretation around the quarterly earnings announcements. 4.2. Regression results Our initial analysis of the logit regressions indicated that the variance in the data was greater than that predicted by the binomial model (an over-dispersion The Authors

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Table 3 Summary descriptive statistics of earnings characteristics, rm characteristics and control variables Panel A: Descriptive statisticsa Percentile N Earnings characteristics Predict 14 043 Persist 14 043 AbsFE 28 576 NegEPS 28 576 Firm characteristics MV 28 576 StdCash 14 043 P/B 28 576 Coverage 14 043 Control variables AbsRev 28 576 Mean SD 1st 25th 50th 75th 99th

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0.0467 0.3929 0.0053 0.1134 8334 0.0742 3.64 18.4323 0.0076

0.0687 0.3903 0.0296 0.3171 23 758 0.0780 50.76 10.77 0.0243

0.2938 0.4854 0.0000 0 69 0.0113 0.52 3 0.0000

0.0527 0.1456 0.0005 0 730 0.0358 1.44 10 0.0011

0.0285 0.4129 0.0013 0 2065 0.0558 2.13 16 0.0029

0.0164 0.6349 0.0037 0 5858 0.0872 3.35 25 0.0073

0.0035 1.3704 0.0624 1 118 071 0.3716 17.68 49 0.0696

Panel B: Simple correlations of the percentage of analysts differential revisions and decile rank of independent variablesb Divergences Flips Divergences Inconsistencies 0.3789 <0.0001 Inconsistencies 0.7966 <0.0001 0.7734 <0.0001 Predict 0.0202 0.0006 0.0201 0.0007 0.0256 <0.0001 Persist 0.0174 0.0033 0.0070 0.2363 0.0118 0.0460 AbsFE 0.0728 <0.0001 0.0329 <0.0001 0.0769 <0.0001 NegEPS 0.0058 0.3312 0.0040 0.5023 0.0046 0.4397 lnMV 0.0240 <0.0001 0.0316 <0.0001 0.0340 <0.0001 StdCash 0.0193 0.0011 0.0199 0.0008 0.0258 <0.0001 P/B 0.0254 <0.0001 0.0450 <0.0001 0.0409 <0.0001 Coverage 0.0149 0.0119 0.0260 <0.0001 0.0201 0.0007 AbsRev 0.1938 <0.0001 0.2002 <0.0001 0.2613 <0.0001

Panel B: Simple correlations of the percentage of analysts differential revisions and decile rank of independent variablesb Divergences Inconsistencies Predict Persist 0.2211 <0.0001 AbsFE 0.2373 <0.0001 0.0360 <0.0001 NegEPS 0.2378 <0.0001 0.0012 0.8387 0.3091 <0.0001 lnMV 0.3026 <0.0001 0.0561 <0.0001 0.3280 <0.0001 0.2544 <0.0001 StdCash 0.6810 <0.0001 0.0674 <0.0001 0.1524 <0.0001 0.1835 <0.0001 0.3429 <0.0001 P/B 0.1519 <0.0001 0.0387 <0.0001 0. 2004 <0.0001 0.1142 <0.0001 0.6804 <0.0001 0.2056 <0.0001 Coverage 0.0700 <0.0001 0.0246 <0.0001 0.4215 <0.0001 0.2024 <0.0001 0.2683 <0.0001 0.1166 <0.0001 0.1344 <0.0001 AbsRev 0.2460 <0.0001 0.0337 <0.0001 0.6225 <0.0001 0.3141 <0.0001 0.3211 <0.0001 0.1539 <0.0001 0.2073 <0.0001 0.4212 <0.0001

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Predict Persist AbsFE NegEPS lnMV StdCash P/B Coverage

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For the descriptive statistics, we use the sample rms and analysts used in Window 3. bAll variables other than Flips, Divergences and Inconsistencies are computed by ranking the unranked variables within their industry-year and converting ranks to deciles. Listed below each correlation is the p-value. Flips is the post pre post pre pre post post proportion of analyst pairs that move in opposite directions and ip. A Flip = 1 if sign( Fi,pre q, t F i,q, t ) sign( Fj ,q, t Fj ,q, t ), F i,q, t > Fj ,q, t and F i,q, t < Fj ,q, t for two pre pre pre analysts i j and Fi,q, t > Fj,q, t , where for a given quarter q earnings announcement in scal year t + 1, Fi,q,t = analyst is year t annual earnings announcement in quarter q pre-announcement (if superscript = pre) or post-announcement (if superscript = post); Divergences is the proportion of analyst pairs that move in post pre post pre pre post post opposite directions and diverge. A Divergence = 1 if sign( Fi,pre q, t F i,q, t ) sign( Fj ,q, t Fj ,q, t ), | F i,q, t Fj ,q, t | < | F i,q, t Fj ,q, t | ; Inconsistencies is the proportion of analyst pairs that move in opposite directions and either ip or diverge. Predict is the standard deviation of forecast errors from an autoregressive model of order one (AR1) for earnings before extraordinary item scaled by the average assets over the preceding 10 years; Persist is rm-specic value of the coefcient on lagged earnings in time-series AR1 model over the preceding 10 years; AbsFE is absolute mean analyst forecast error divided by quarter q end stock price; NegEPS is dummy variable equalling 1 if negative EPS reported in I/B/E/S Actual File; MV (lnMV) is (log of) market value measured by scal year ending stock price multiplied by the number of shares outstanding; StdCash is standard deviation of operating cash ows over the preceding 10 years; P/B is price-to-book ratio at quarter ending date; Coverage is (log of ) number of analyst following; AbsRev is absolute value of change in mean analyst forecasts around an earnings announcement divided by quarter q end stock price. SD, standard deviation.

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problem). One way of correcting for over-dispersion is to multiply the covariance matrix by a dispersion parameter estimation (McCullagh and Nelder, 1989). Therefore, we followed the method in Williams (1982) to estimate the dispersion parameter and correct for over-dispersion.14 Table 4 reports the results of our cross-sectional logit regressions of the Kandel and Pearson (1995) forecast measures of differential interpretation. Panel A presents the results for Flips, Panel B presents the results for Divergences, and Panel C presents the results for Inconsistencies. The results for all three dependent variables are essentially the same. Regarding the earnings-related variables, we nd that the Kandel and Pearson (1995) measures are consistently negatively associated with Predict and positively associated with AbsFE and NegEPS (all p < 0.01) after controlling for AbsRev. These results are consistent with our predictions and suggest that differential interpretation is decreasing in the precision of earnings. The coefcient for Persist, in contrast, is insignicant in the regression models except the regression model for Divergences with earnings-related variables in the model. Regarding the rm-related variables, we nd that the three Kandel and Pearson (1995) measures are consistently negatively associated with lnMV (p < 0.05 or p < 0.01) and P/B (p < 0.01), and positively associated with Coverage (p < 0.05 or p < 0.01). The results for lnMV and P/B suggest that, consistent with expectations, differential interpretation is lower when a rm has a richer information environment or when it is costly to analyse a rms value. The results for Coverage suggest that differential interpretation is higher when there are more information processors following a rm. However, the coefcient on StdCash switches from being signicantly positive ( p < 0.01) when included with just the rm variables to being marginally negative ( p < 0.10) in the full model. This result appears to be due to multicollinearity between StdCash and our Predict variable. When we remove Predict from the full model, we get a signicantly positive coefcient on StdCash as predicted. The evidence in Table 4 supports the evidence in Kandel and Pearson (1995), Barron et al. (2002) and Barron et al. (2005) that analysts use private, idiosyncratic information to interpret public earnings announcement. However, our evidence extends this line of research by showing that differential interpretation of earnings is a function of earnings and rm characteristics. In particular, we nd that differential interpretation is reduced by earnings characteristics reecting the quality of the earnings and by rm characteristics reecting the quality of pre-announcement disclosure and the cost of analysing a rms value. We now present tests examining the sensitivity and robustness of our results.

14 The William method is appropriate for the proportional form of data with unequal size. As an alternative, we also estimate the dispersion parameter based on the Pearson chisquared statistic and the deviation for the tted model, but the results are similar. We use SAS software for these tests.

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 The Authors

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Table 4 Results of cross-sectional logit regression of forecast revisions reecting differential interpretationa,b Proportion of differential revisions = + 1Predictj,t + 2Persistj,t + 3AbsFEj,q,t + 4NegEPSj,q,t + 5 ln MVj,q,t + 6StdCashj,t + 7P/Bj,q,t + 8Coveragej,t + 9AbsREVj,q,t + Quarter Dummies + Year Dummies + j,q,t. Panel A: Results of Flips on decile ranks of characteristics of rms and earnings around quarterly earnings announcements (n = 28 756) Intercept 1.688*** (1079.6) 0.6609*** (27.4) 0.5958*** (18.22) Predict 0.039*** (43.5) Persist 0.001 (0.0) AbsFE 0.060*** (135.5) NegEPS 0.491*** (156.3) 0.0818** (21.7) 0.0417** (5.6) 0.0266*** 0.1251*** (21.5) (402.1) 0.0190** 0.1060*** (6.6) (274.7) lnMV StdCash P/B Coverage AbsRev Pseudo R2 0.0403 0.0416 0.0462

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0.0632*** (65.8)

0.0034 (0.6)

0.0359*** (47.3)

0.3949*** (97.8)

0.225*** (1883) 0.0401** 0.2195*** (8.0) (1998) 0.0193 0.2478*** (1.8) (2189)

Panel B: Results of divergences on decile ranks of characteristics of rms and earnings around quarterly earnings announcements (n = 28 756) Intercept 1.978*** (1182.4) 1.1027*** (59.9) 1.1489*** (53.21) Predict 0.034*** (27.2) Persist AbsFE NegEPS 0.462*** (110.8) lnMV StdCash P/B Coverage AbsRev Pseudo R2 0.0478 0.0479 0.0545

0.012** 0.089*** (5.5) (247.1)

0.0625*** (51.6)

0.0070 (2.0)

0.247*** (1832) 0.0917*** 0.0228*** 0.1391*** 0.0858*** 0.2299*** (21.8) (12.5) (402.7) (28.1) (1745) 0.0642*** 0.3688*** 0.0482** 0.0235*** 0.1110*** 0.0656*** 0.2677*** (120.7) (67.2) (6.0) (8.1) (242.5) (16.4) (2050)

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Table 4 (continued) Panel C: Results of inconsistencies on decile ranks of characteristics of rms and earnings around quarterly earnings announcements (n = 28 756) Intercept 1.199*** (620.5) 0.0962 (0.7) 0.0520 (0.16) Predict 0.040*** (54.2) Persist 0.007 (2.8) AbsFE 0.078*** (264.3) NegEPS 0.543*** (213.2) lnMV StdCash P/B Coverage AbsRev Pseudo R2 0.0568 0.0577 0.0647 0.0700*** (92.4) 0.0929*** (32.9) 0.0023 0.0520*** 0.4441*** 0.0474** (0.3) (111.5) (137) (8.4) 0.262*** (2830) 0.0278*** 0.1428*** 0.0570*** 0.2510*** (26.8) (591.7) (19.3) (2888) 0.0234*** 0.1193*** 0.0349** 0.2884*** (11.5) (393.3) (7.3) (3218) ***, ** and * denote statistical signicance at the 1, 5 and 10 per cent levels, respectively. aAll variables other than Flips, Divergences and Inconsistencies are ranked and then computed as deciles within the industry-year, bChi-squared statistics are presented in parentheses. Predict is the standard deviation of forecast errors from an autoregressive model of order one (AR1) for earnings before extraordinary item scaled by the average assets over the preceding 10 years; Persist is rm-specic value of the coefcient on lagged earnings in time-series AR1 model over the preceding 10 years; AbsFE is absolute mean analyst forecast error divided by quarter q end stock price; NegEPS is dummy variable equalling 1 if negative EPS reported in I/B/E/S Actual File; MV (lnMV) is (log of) market value measured by scal year ending stock price multiplied by the number of shares outstanding; StdCash is standard deviation of operating cash ows over the preceding 10 years; P/B is price-to-book ratio at quarter ending date; Coverage is (log of ) number of analyst following; AbsRev is absolute value of change in mean analyst forecasts around an earnings announcement divided by quarter q end stock price.

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241

5. Sensitivity and robustness tests 5.1. Subsample of analyst forecasts revised on the same day Prior evidence shows that analysts learn from prior forecasts or stock price (Stickel, 1990). This additional information acquisition by analysts who issue forecasts later in the post-announcement period can lead to different information sets among analysts and result in differential forecast revisions. Although our 15 days of post-announcement period is short enough to assume that analysts revise their forecasts to interpret earnings announcement, we cannot exclude the possibility that analysts additional information acquisition in the post-announcement period causes analysts to revise their forecasts differently. To mitigate this concern, we repeat our analyses with forecasts that are even more restricted in their timing. In particular, we compose forecast revision pairs with forecasts that are revised on the same date in the post-announcement period. Because these forecasts are revised on the same date, analysts in each pair are more likely to observe the same prior public information. This will better control for information differences due to different forecast timing across analysts. The results, reported in Table 5, are similar to those reported in Table 4. We nd consistently negative coefcients on Predict, P/B and AbsRev. We also nd consistently positive coefcients on AbsFE and NegEPS. Inconsistent with Table 4, the coefcient on lnMV is insignicant for all three Kandel and Pearson (1995) measures and the coefcient on Coverage is only marginally signicantly positive for Divergences. This evidence suggests that our results are unlikely to be driven by forecast timing differences. 5.2. Analyst forecast dispersion Analyst forecast dispersion in the pre-announcement period is widely used to proxy for earnings predictability or uncertainty (e.g. Imhoff and Lobo, 1992; Atiase and Bamber, 1994). We compute analyst forecast dispersion using the standard deviation of annual earnings forecasts in the pre-announcement period deated by quarter-end stock price. We nd that forecast dispersion in the pre-announcement period is highly positively correlated to our earnings predictability variable, Predict. Furthermore, when we replace the variable Predict with forecast dispersion, we nd a strongly positive coefcient on forecast dispersion in all regression models. This is consistent with the notion that analysts are more likely to rely on private information to revise their forecasts when the public information environment is less precise. 5.3. Forecast bias Prior research suggests that analysts systematically issue optimistic forecasts for annual earnings (e.g. Abarbanell and Bernard, 1992; Francis and Philbrick, The Authors

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Table 5 Results of cross-sectional logit regression of forecast revisions reecting differential interpretation with subsample of forecasts revised on the same date in postannouncement period (n = 16 235)a,b Proportion of differential revisions = + 1Predictj,t + 2Persistj,t + 3AbsFEj,q,t + 4NegEPSj,q,t + 5 ln MVj,q,t + 6StdCashj,t + 7P/Bj,q,t + 8Coveragej,t + 9AbsREVj,q,t + Quarter Dummies + Year Dummies + j,q,t. Intercept Predict Persist AbsFE NegEPS lnMV StdCash P/B Coverage AbsRev Pseudo R2

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Panel A: Flips 0.6744** 0.0622*** (8.62) (24.5) Panel B: Divergences 1.2894*** 0.0714*** (23.09) (24.1) Panel C: Inconsistencies 0.2223 0.0759*** (1.11) (42.8)

0.0011 (0.0)

0.0370*** (19.3)

0.4354*** (49.0)

0.0074 (0.1)

0.0238* (4.1)

0.1140*** (122.1)

0.0122 (0.3)

0.2392*** (798.7)

0.0421

0.0166* (4.0)

0.0658*** (45.8)

0.4108*** (32.5)

0.0292 (0.8)

0.0373** (7.5)

0.1133*** (91.9)

0.0528 (3.7)

0.2546*** (687)

0.0491

0.0069 (1.1)

0.0533*** (46.6)

0.4710*** (65.9)

0.0162 (0.4)

0.0333** (9.4)

0.1238*** (168)

0.0149 (0.5)

0.2740*** (1184)

0.0564

***, ** and * denote statistical signicance at the 1, 5 and 10 per cent levels, respectively. aAll variables other than Flips, Divergences and Inconsistencies are ranked and then computed as deciles within the industry-year. bChi-squared statistics are presented in parentheses. Predict is the standard deviation of forecast errors from an autoregressive model of order one (AR1) for earnings before extraordinary item scaled by the average assets over the preceding 10 years; Persist is rm-specic value of the coefcient on lagged earnings in time-series AR1 model over the preceding 10 years; AbsFE is absolute mean analyst forecast error divided by quarter q end stock price; NegEPS is dummy variable equalling 1 if negative EPS reported in I/B/E/S Actual File; MV (lnMV ) is (log of ) market value measured by scal year ending stock price multiplied by the number of shares outstanding; StdCash is standard deviation of operating cash ows over the preceding 10 years; P/B is price-to-book ratio at quarter ending date; Coverage is (log of ) number of analyst following; AbsRev is absolute value of change in mean analyst forecasts around an earnings announcement divided by quarter q end stock price.

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1993; Easterwood and Nutt, 1999). However, this forecast bias is unlikely to affect our results. First, recent evidence in Brown (2001) and Matsumoto (2002) suggests that analysts apparent optimistic bias is diminishing, that analysts appear to be optimistic for only some periods, and that much of analysts optimism arises from rms reporting losses. We repeat our tests with sample rms that do not have losses, and the results are similar. Second, the Kandel and Pearson (1995) measures are less likely to be affected by analysts forecast bias because they capture forecast revisions that move in different directions. Therefore, systematic optimism (or pessimism) in analysts forecasts is unlikely to affect our measures of differential interpretation. 5.4. Analyst self-selection Analysts might simply drop a rm rather than issue a negative forecast, even though they observe signicant new information from an earnings announcement. Empirical evidence shows that analysts tend not to follow rms when there is bad news (McNichols and OBrien, 1997). This analyst self-selection could potentially affect our results by limiting differential interpretation of bad news. This concern is mitigated by two results. First, we nd that our variable NegEPS is positively related to the Kandel and Pearson (1995) measures of differential interpretation. Second, as mentioned above, limiting our sample rms to positive EPS announcements does not change our main results. 6. Conclusion Although empirical researchers have documented the existence of differential interpretation of earnings announcements (Kandel and Pearson, 1995; Bamber et al., 1999; Barron et al., 2002, 2005), the factors that drive this differential interpretation remain unknown. We ll this gap in the literature by providing evidence on the determinants of differential interpretation of an earnings announcement. We nd that differential interpretation of earnings is: (i) reduced by earnings characteristics reecting the quality of the earnings; (ii) reduced by rm characteristics reecting the quality of pre-announcement disclosure; and (iii) reduced by rm characteristics reecting the cost of acquiring private information to interpret earnings idiosyncratically. Our study has several limitations. First, we use forecast measures of differential interpretation that require recent forecast updates around earnings announcements. Because of this data requirement, our sample includes relatively large rms with a large analyst following. Therefore, it is not clear how our results would generalize to a sample of rms with different characteristics. Second, our measure of differential interpretation captures more extreme cases of newfound disagreement among nancial analysts. Hence, our results might not generalize to less extreme cases of differential interpretation or less sophisticated market participants. These issues are fruitful areas for future research. Despite these The Authors

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limitations, our results should be of interest to researchers and regulators. By identifying earnings and rm characteristics that affect differential interpretation, we are able to provide insights as to the conditions under which an earnings announcement is less likely to generate newfound disagreement among analysts and investors. This is important because recent theory and evidence suggests that investor disagreement can increase investment risk, increase the cost of capital, and cause stock prices to deviate from fundamental value. References
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