Differential Earnings Behavior and the Security Market Assessment of Variation in Seasonal Earnings Patterns

Abstract

We provide new evidence regarding the anomalous security market behavior that pertains to the predictability of abnormal security returns at future quarterly earnings announcements (Bernard and Thomas [1990]) as well as the security market's ability to form quarterly earnings expectations that are consistent with the market factoring in the serial correlation in the seasonally differenced quarterly earnings series (Ball and Bartov [1996]; Soffer and Lys [1999]). Consistent with extant work, we find that just prior to the quarterly earnings announcement date, the security market's expectation of quarterly earnings is consistent with the market recognizing the serial correlation in seasonally differenced quarterly earnings but underestimating its magnitude. When we treat all firms as exhibiting the same quarterly earnings process, our results reinforce the findings of Soffer and Lys (1999) that security market earnings expectations at the beginning of the quarter are consistent with investors not recognizing the serial correlation in the seasonally differenced quarterly earnings series. By distinguishing between those firms whose quarterly earnings process is inconsistent with a seasonal random walk (SRW) process (i.e., “bad-fit” firms) vis-à-vis those firms whose quarterly earnings process is better described by the SRW process (i.e., “good-fit” firms), we provide additional insights on this relationship throughout the quarter leading up to the quarterly earnings announcement date. Specifically, we find that security market expectations of quarterly earnings are consistent with a market that recognizes the differential time-series properties of quarterly earnings. That is, at the beginning of the quarter, for the “bad-fit” (“good-fit”) firms, we find that the security market acts as if it is aware (unaware) of the correct sign of the serial correlation in the seasonally differenced quarterly earnings series. However, the security market still acts as if it underestimates the magnitude of the serial correlation.