Nichols & Wahlen 2023

ACCOUNTING HORIZONS American Accounting Association
Vol. 37, No. 2 DOI: 10.2308/HORIZONS-18-075

June 2023
pp. 105–132
The Essential Role of Accounting Information in the

Capital Markets: Updating Seminal Research
Results with Current Evidence
D. Craig Nichols
Syracuse University
James M. Wahlen
Indiana University Bloomington
SYNOPSIS: An extensive literature of empirical research over the past 50+ years provides important insights into the
role of accounting information in the equity capital markets. But how has the role of accounting information changed,
given advancements in the dissemination and processing of accounting information, as well as changes in corporate
governance, securities regulations, and trading? In this paper, we use recent data to examine whether seminal findings
from prior studies in the following three major areas of research still hold: the earnings-returns relation, earnings
management, and market efficiency. We also introduce some new findings that were not in the original studies. We use
a framework that maps firms’ business activities into share prices and provide straightforward descriptions of the
research methodologies, empirical findings, and important implications from the evidence to benefit accounting
students, instructors, practitioners, and others who may not yet have been exposed to this research.
Data Availability: Data are available from the public sources cited in the text.
JEL Classifications: D22; D80; G10; G12; G14; M41.
Keywords: earnings information; unexpected earnings; abnormal returns; market efficiency; earnings management.
I. INTRODUCTION
T
o fully appreciate the importance of financial accounting and reporting, it is essential to understand the eco-
nomic consequences of accounting information in the capital markets. The relation between financial accounting
information and stock prices reveals insights into the economic relevance of financial reporting as a source of
firm-specific information that has important implications for how the capital markets allocate capital and value shares.1
Scholars have been examining the capital market consequences of accounting information for over 50 years, beginning
with the landmark studies of Ball and Brown (1968) and Beaver (1968). Those studies were the first to demonstrate the
associations between accounting income numbers, share trading activity, and changes in share prices, triggering a major
shift in the accounting research paradigm.2 Since then, accounting academics have developed a large body of theory and
a wealth of empirical evidence on the complex and dynamic relations between accounting information and stock prices.
We are grateful for thoughtful and constructive comments from Ray Ball, the editor, and two reviewers.
D. Craig Nichols, Syracuse University, Whitman School of Management, Accounting Department, Syracuse, NY, USA; James M. Wahlen, Indiana
University Bloomington, Kelley School of Business, Accounting Department, Bloomington, IN, USA.
Editor’s note: Accepted by Carol Marquardt, under the Senior Editorship of Gopal V. Krishnan.
Submitted: November 2021

Accepted: June 2022
Early Access: June 2022
1
Of course, financial accounting information plays important roles in many other contexts, too, including lending, contracting, corporate manage-
ment and governance, management compensation, mergers and acquisitions, and regulation. In this article, we focus specifically on the role of
accounting information within public equity capital markets.
2
Prior to Ball and Brown (1968) and Beaver (1968), accounting research generally focused on theoretical and conceptual development of the desirable
attributes of useful accounting information. Although this approach can be helpful, it is limited because it does not provide empirical evidence to val-
idate usefulness.
105
106 Nichols and Wahlen
Since the turn of this century, a number of fundamental changes have occurred in the capital market’s information
environment, including the following:
• Substantial developments in U.S. GAAP and International Financial Reporting Standards (IFRS);
• Innovations in technology that accelerate the dissemination of earnings information and reduce the costs of
acquiring and processing that information;
• Enhanced capital market regulations, including the Sarbanes-Oxley Act of 2002;
• Changes in firms’ business models and global activities, including increasing expenditures to internally develop
intangible assets (such as research and development to create intellectual property, advertising to create brand
names, and others) that are expensed immediately and are not capitalized on balance sheets or amortized over
useful lives in income statements;
• Significant expansion in information released with earnings announcements, including a greater frequency of
management guidance for future earnings and more frequent SEC filings (e.g., Form 10-K) on the same day;
• More frequent reporting and use of non-GAAP performance measures;
• Leaps forward in the speed and efficiency of share trading activities; and
• Substantial increases in trading activities that are not directly linked to firm-specific accounting information, such
as algorithmic trading and exchange-traded funds.
To what extent have developments like these impacted the fundamental relations between accounting information
and stock prices? This paper uses accounting and stock price data from 2002 through 2019 to re-examine the following
three sets of findings from capital markets-based accounting research that may have changed in recent years: the
earnings-returns relation, earnings management, and market efficiency.3 This paper provides straightforward descrip-
tions of the research methods and findings for readers who may not have extensive training in research methodology
and econometrics.
To re-examine the capital market consequences of accounting information, we organize this paper using the follow-
ing three-step framework that maps firms’ business activities into share prices:
• Step 1: Financial reporting. Each period, financial statement preparers measure and report information about the
firm’s business transactions, events, arrangements, and activities in a set of financial statements.
• Step 2: Analysis and valuation. Investors and analysts use financial statements and a wide array of other informa-
tion to develop expectations about future earnings, cash flows, and dividends and then use those expectations to
estimate share values.
• Step 3: Share trading and pricing. Investors use their information and share value estimates to buy and sell shares.
These trading activities determine share prices in the equity capital markets.
When all three steps function effectively, the financial reporting process provides useful information about firms’
financial position and performance, which impacts investors’ and analysts’ expectations about future earnings and cash
flows and, therefore, share values. Changes in share value estimates trigger share trading, which in turn causes share pri-
ces to change in the capital markets.4
Some evidence suggests that the value-relevance of accounting information has deteriorated over the past two deca-
des because of accounting conservatism relative to the heightened importance of intangible assets and intellectual prop-
erty in firms’ business models, as well as the increasing reporting of non-GAAP performance measures (e.g., Lev and
Gu 2016; Balachandran and Mohanram 2011; Collins, Maydew, and Weiss 1997). In addition, recent years have also
witnessed a surge in algorithmic trading and exchange-traded funds that may weaken the link between firm-specific fun-
damentals and share prices (Weller 2018; Blankespoor, deHaan, Wertz, and Zhu 2019). However, Beaver, McNichols,
and Wang (2018) report evidence that documents a dramatic increase since 2001 in stock return volatility during three-
day windows around earnings announcements, which suggests an increase in value-relevant earnings information. To
what extent has the usefulness of earnings information changed over time?
Our first set of results provides evidence on steps 1 through 3 by showing a significant relation between the sign of
the change in annual earnings and annual stock returns over the same period, updating Ball and Brown (1968). Firms
that reported earnings increases experienced stock returns that were on average 12.3 percent higher than the returns of
similar size firms during the same period of time. In contrast, firms that reported earnings decreases experienced stock
returns that were on average 13.1 percent lower than similar size firms’ returns. These results suggest that even
3
A prior study, Nichols and Wahlen (2004), introduces updated empirical evidence on the earnings-returns relation using data from 1988 to 2002.
That study focused specifically on the association between changes in earnings and stock returns, the impact of earnings persistence on stock returns,
and post-earnings-announcement drift.
4
For more extensive and detailed surveys of the research literature on the relation between earnings and returns, see Lev (1989), Bernard (1989),
Beaver (1997), Kothari (2001), Lee (2001), and Scott (2003).
Accounting Horizons
Volume 37, Number 2, 2023
The Essential Role of Accounting Information in the Capital Markets 107
information as simple as the sign of the change in earnings relates to an average difference of 25.4 percent in annual
stock returns.
We benchmark these abnormal returns by sorting our sample firms into two portfolios each year, namely, one
including the stocks that experienced positive abnormal returns over the next year and the other including the stocks
that experienced negative abnormal returns over the next year. With perfect foresight of the sign of one-year-ahead
abnormal returns, the positive returns portfolio experienced average abnormal returns of 43.2 percent per year, whereas
the negative returns portfolio experienced average abnormal returns of 31.9 percent, which is a spread of 75.1 percent.
This benchmark indicates that, on average, changes in earnings are associated with roughly one-third (33.8 percent ¼
25.4 percent/75.1 percent) of the information impounded in share prices during the year.
Recent years have seen an increasing number of firms reporting non-GAAP performance measures like EBITDA
(earnings before interest, taxes, depreciation, and amortization) and pro forma earnings. To what extent are the capital
markets substituting these performance measures for earnings? We find that the capital markets draw substantially more
value-relevant information from changes in annual earnings than either changes in EBITDA or changes in annual cash
flows from operations, highlighting the importance of the accrual accounting information in earnings (step 1: financial
reporting).
Given the technological innovations in information dissemination, the expansion of large amounts of information
released with earnings announcements, and the increasing use of trading mechanisms that are not linked to firm-specific
earnings information, we look more closely at the earnings-returns relation to examine when the capital market reacts to
earnings news. Like Beaver et al. (2018), we find that share prices react quickly to quarterly earnings news announce-
ments. Over the ten-day period surrounding quarterly earnings announcements, stock prices for the firms announcing
the largest earnings increases rose on average 4.7 percent, whereas stock prices for the firms announcing the largest earn-
ings decreases fell by an average of 4.1 percent. Of this 8.8 percent difference in announcement period returns, 7.0 per-
cent occurs on the announcement day and the following day. These results show that quarterly earnings announcements
still convey new information (step 1) and reveal that market participants process (step 2) and trade (step 3) on that infor-
mation quickly.
Taking a step further, does the information impounded in share prices relate to earnings beyond the current year? If
the current period change in earnings is associated with roughly one-third of the information impounded in share prices,
does the additional two-thirds of the information impounded in share values (steps 2 and 3) predict future earnings? To
address this question, we formed portfolios each year by using a nested sort procedure that allows current period returns
to vary while holding current period earnings changes constant. Controlling for current period changes in earnings, the
results indicate that stocks with the highest abnormal returns in the current year are more likely to experience earnings
increases in year +1, whereas stocks with the lowest abnormal returns in the current year are more likely to experience
earnings declines in year +1. The difference in year +1 earnings changes amounts to 2.0 percent of total assets. This dif-
ference is economically significant because the median firm in our sample generates earnings equal to 3.5 percent of total
assets. Thus, the changes in stock prices during the current year reflect not only current year earnings news, but also por-
tend changes in next year’s earnings.
The empirical results to this point indicate that the three steps mapping business activities to financial reports to
share values and capital market prices continue to operate well, despite major changes in the market’s information envi-
ronment. But these steps do not completely explain share prices or stock returns. What are potential sources of slippage
in each of the three steps?
Because earnings information is associated with important capital market consequences, a significant stream of
accounting research asks the following: do firm managers influence the financial reporting process (step 1) to report
higher earnings in order to meet or beat earnings expectations?5 Prior studies find unusual patterns in the distributions
of earnings numbers around earnings benchmarks, including meeting or beating analysts’ forecasts, avoiding reporting
losses, and avoiding reporting earnings declines (e.g., Burgstahler and Dichev 1997; Degeorge, Patel, and Zeckhauser
1999). These results imply that firm managers influence the financial reporting process to manage earnings up, especially
if earnings numbers would otherwise fall short of benchmarks. However, it is possible that in the post-Sarbanes-Oxley
2002 era, with more rigorous auditing and corporate governance, tighter securities regulation (e.g., SAB 99), and height-
ened awareness among executives of their responsibility for reported earnings numbers, the frequency with which man-
agers intervene in the financial reporting process may have diminished.6 Also, as noted earlier, given the increased
5
Other studies in the earnings management research literature examine whether mangers influence reported earnings to affect other economic conse-
quences, including avoiding violating debt covenants, influencing earnings-based compensation and bonus payments, meeting certain regulatory
requirements, and affecting accounting-based corporate governance mechanisms (see Healy and Wahlen (1999) for a review).
6
The SEC issued Staff Accounting Bulletin 99 (SAB 99) to address earnings management concerns. SAB 99 deems any accounting error material if
the error allowed the firm to reach any one of the three earnings benchmarks mentioned above.
Accounting Horizons
reporting of non-GAAP performance measures, perhaps managers are less concerned about meeting or beating GAAP-
based earnings expectations. Consequently, it is not clear whether the prior evidence on earnings management to meet
or beat benchmarks persists in recent years.
To re-examine earnings management, we extend the earnings distribution tests using reported quarterly earnings
numbers and analysts’ consensus earnings forecasts (as proxies for the market’s expectations) as benchmarks. Like the
prior studies, our evidence indicates that more firms than expected report earnings that meet or beat analysts’ forecasts,
and fewer firms than expected report earnings that are just below analysts’ forecasts. However, our evidence is weaker
than the findings in the original studies. The spikes in earnings distributions just above and just below the benchmarks
are still observable, but are smaller than they were in the early studies. This evidence suggests that managers continue to
intervene in the financial reporting process (slippage in step 1) to manage earnings upward to meet or beat analysts’
earnings forecasts, but the frequency of this behavior has diminished.
In our final set of analyses, we revisit the seminal findings of Bernard and Thomas (1989, 1990), who documented
that stock prices continue to drift after earnings announcements, suggesting the capital markets were not perfectly effi-
cient in reacting quickly to earnings surprises (slippage in steps 2 and 3). The decades since the Bernard and Thomas
(1989, 1990) study period have seen innovations in technology that accelerate the dissemination of earnings information
and reduce the costs of acquiring and processing that information, as well as faster and less costly share trading activi-
ties. In addition, the findings of Bernard and Thomas (1989, 1990) are well known, so sophisticated market participants
should be aware of the potential to earn excess returns following earnings announcements. Have these developments
and the incentives to earn post-earnings-announcement returns enhanced the degree of market efficiency with respect to
earnings information?
During the 60 trading days leading up to quarterly earnings announcements, the firms in the top decile of earnings
increases each quarter experienced average abnormal returns of 7.3 percent, whereas the firms in the bottom decile of
earnings decreases experienced negative abnormal returns of 6.2 percent, which is a difference that averaged 13.5 per-
cent. These preannouncement returns are more pronounced than those observed in Bernard and Thomas (roughly 10.4
percent). These results reveal that share prices anticipate earnings news weeks in advance of the actual announcement
(steps 2 and 3). However, during the 60-day period after these earnings announcements, stock prices for the firms that
announced the largest earnings increases continued to rise by an average of 2.1 percent, whereas stock prices for the
firms that announced the largest earnings decreases continued to fall by an average of 0.9 percent. The average 3.0 per-
cent spread we observe in abnormal returns extends the seminal findings on the post-earnings-announcement drift
anomaly documented by Bernard and Thomas (1989, 1990), but is considerably smaller than the 4.2 percent average
post-earnings-announcement drift returns they observed. Taken together, our results suggest that the capital markets are
not yet completely efficient (slippage in steps 2 and 3) with respect to pricing quarterly earnings information, although
the markets have become more efficient, perhaps due to incentives to exploit this anomaly and advances in the efficiency
of share trading.
II. THE RELATION BETWEEN BUSINESS ACTIVITIES AND SHARE PRICES

In this section, we describe the framework underlying the relation between firms’ business activities, financial state-
ments, share value estimates, and share prices.7 We then describe key elements in conducting empirical tests of the rela-
tion between earnings and stock returns.
How Do Business Activities Relate to Share Prices?

The extent to which market prices reflect the implications of accounting information depends on three steps, which
we depict in Figure 1.
Step 1: Financial Reporting

Each period, firms engage in a vast array of different transactions, events, commercial arrangements, and business
activities. Financial statement preparers follow professionally established accounting principles and standards (such as
U.S. GAAP and IFRS) to measure, summarize, and report information about firms’ business activities in balance
sheets, income statements, and statements of cash flows. Reporting financial statements makes firms’ private informa-
tion about their business activities available to external stakeholders.
7
This framework is developed in Nichols, Wahlen, and Wieland (2017).
Accounting Horizons
FIGURE 1
Three Steps Mapping Business Activities into Share Prices
Firms’ Business Activities

(transactions, events, commercial
arrangements)
Step 1: The Financial Reporting Process

Financial statement preparers measure,
summarize, and report the firm’s business
activities in the financial statements.
Step 2: The Analysis and Valuation Process

Investors and analysts map financial statement
information and a wide array of other
information into expectations of future earnings,
cash flows, and dividends, and then map these
expectations into estimates of share values.
Step 3: The Share Trading and Pricing Process

Capital market participants engage in share trading
activities based on their share value estimates,
causing share prices to change.
Share Prices
(The full-color version is available online.)
Step 2: Analysis and Valuation

Investors and analysts use financial statements and a wide array of other information to evaluate firms’ profitability,
growth, and risk. Using this information, they develop expectations about future earnings, cash flows, and dividends. In
fundamental analysis, analysts and investors use various valuation approaches, like the discounted cash flows model
and the residual income model (Ohlson 1995), for estimating share values based on expected future earnings, cash flows,
and dividends.
Step 3: Share Trading and Pricing

Investors trade on their information and their share value estimates, buying or selling shares when they believe share
prices are below or above fundamental values. These trading activities may cause share prices in the equity capital mar-
kets to change. When share prices in the market deviate from fundamental values, these share trading activities should
move prices closer to fundamental values.
Accounting Horizons
When these three steps function effectively, share prices should reflect the value-relevant information that
financial statements provide about firms’ fundamental business activities. However, these three steps do not always
function perfectly. Indeed, many of the fundamental changes in the information environment in the capital markets
over the past 20 years may have weakened these steps. For example, slippage can occur in the financial reporting
process in step 1 when balance sheet and income statement amounts rely on historical costs that no longer reflect
current values (e.g., outdated historical costs for plant and equipment). In addition, some firms rely heavily on
research and development to develop valuable intellectual property or engage in customer service activities and
advertising to establish a valuable brand name. Under GAAP and IFRS, expenditures for most internal develop-
ment activities like these are typically immediately expensed and are not capitalized on balance sheets and amor-
tized over useful lives in income statements. If these activities are successful, they may result in large off-balance
sheet assets and equity, which can result in slippage in step 1. Slippage in step 1 may also arise if accounting earn-
ings determined under GAAP or IFRS provide an incomplete or a biased measure of firm performance. For
example, earnings might be an incomplete measure of firm performance in a given period when a firm launches
successful new products, but it cannot recognize revenues on the income statement until future periods when it sat-
isfies the performance obligations associated with new product sales. In addition, GAAP and IFRS earnings some-
times measure firm performance with an asymmetric conservative bias. For example, firms are required to
recognize losses from impairments of asset values when they occur, but must delay the recognition of gains from
appreciation in asset values until they are realized.
Slippage in step 2, the analysis and valuation process, can arise from poor forecasts and expectations, poor valua-
tion methods, or both. Financial statement information seldom explicitly measures and reports all of the expected future
transactions and events that will impact firm value. And companies differ in the richness of information they report to
investors for forecasting these future business activities, which can create slippage in analysts’ and investors’ forecasts
and value estimates. Also, to the extent that analysts’ and investors’ forecasts of future performance are influenced by
firms’ reports of non-GAAP performance measures that overstate (or understate) financial performance and growth rel-
ative to the GAAP–based performance measures, it may also cause slippage in step 2. Further slippage can arise when
analysts and investors do not conduct careful analysis and valuation and instead rely on simplistic valuation heuristics
(e.g., price-earnings ratios).
Step 3 assumes share trading is informed by analysts’ and investors’ share value estimates based on accounting
information. However, trading often occurs for many other reasons. For example, slippage in step 3 can arise from
liquidity trading (e.g., selling shares to meet cash needs), noise trading (e.g., trading on rumors), market frictions (e.g.,
wide bid-ask spreads or short-sale restrictions), and market sentiment (e.g., bubbles and crashes), which can lead to tem-
porary departures of share prices from fundamental values. In addition, the increasingly large amounts of capital traded
each day based on algorithms, or based on asset allocation restrictions (e.g., exchange traded funds), which may not link
directly to firm-specific accounting information, can also induce slippage in step 3 (Weller 2018; Blankespoor et al.
2019).8
How Do We Test the Relation between Earnings and Stock Returns?

The theory explaining the relation between earnings information and stock prices makes three general predictions
(Beaver 1997).9 First, the theory predicts that earnings numbers (or, more broadly, financial statements) provide infor-
mation to equity shareholders about current period profitability. Second, the theory predicts that current period
accounting information helps analysts and investors develop expectations about the firm’s future earnings, cash flows,
and dividends. Indeed, the FASB’s Conceptual Framework for Financial Reporting states, “The objective of general
purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and
potential investors, lenders and other creditors in making decisions about providing resources to the entity, [ … ] which
depend on their assessment of the amounts, timing and uncertainty of future cash inflows to the entity.” (Financial
Accounting Standards Board (FASB) 2021). Third, the theory predicts that share price equals the present value
of expected future cash flows into the firm, which should equal expected future dividend payments to shareholders.
8
For example, Weller (2018) finds that the information content in security prices is decreasing in the level of algorithmic trading activity. In addition,
Blankespoor et al. (2019) find that when individual investors are presented with automatically generated news articles containing firm-specific earn-
ings news and past stock returns, their trading behavior reflects past stock returns (consistent with many algorithmic trading mechanisms) and does
not incorporate the readily available earnings news.
9
This theoretical framework is developed in the seminal text by Beaver (1997, particularly in Chapter 4, 69–74).
Accounting Horizons
The theory predicts that new accounting information (e.g., unexpected earnings) that triggers a change in investors’
expectations for future cash flows and dividends should trigger a change in the share value of the firm.10
To test these predictions with empirical data, researchers examine the associations between changes in earnings
numbers and changes in stock prices. Isolating and testing these associations depend on numerous factors, each of which
is difficult to precisely specify in empirical tests. Although many different factors come into play across different research
designs, researchers commonly have to carefully consider the following five factors:
• Earnings information,
• Earnings expectations and unexpected earnings,
• Earnings persistence,
• Market efficiency, and
• Risk-adjusted stock returns.
Because of the dynamic nature of these five factors in the capital markets, accounting researchers cannot run con-
trolled experiments in the stock market to isolate one factor at a time (unlike a scientist who can run controlled experi-
ments in a laboratory).11 So we cannot be certain that accounting information causes stock market price reactions.
Instead, we rely on carefully constructed econometric tests to isolate and examine the association (the correlation)
between unexpected earnings and risk-adjusted stock returns. We next describe how researchers address each of these
five factors. Following these descriptions, we illustrate with a simple numerical example of how earnings information
can trigger changes in share prices.
Earnings Information
The first factor above, earnings information, is the central variable of interest. Do earnings numbers convey infor-
mation that the capital markets use to price shares? Despite the effectiveness of accrual accounting and GAAP, earnings
numbers might not provide useful information to the capital markets. For example, financial press reports, changes in
economic indicators, or firm-specific announcements might preempt accounting earnings as a timely source of informa-
tion. Also, as noted above, slippage in step 1 may cause accounting earnings determined under GAAP to be an incom-
plete or conservatively biased measure of firm performance in a given period. Moreover, market participants may be
wary that some firms under certain conditions may attempt to report managed earnings numbers that are not reliable
indicators of economic performance. If factors like these destroy the usefulness of accounting earnings, then we should
observe no association between accounting earnings and stock returns.
Earnings Expectations and Unexpected Earnings

The second factor, earnings expectations and unexpected earnings, seeks to identify the new information in current
period earnings. As noted earlier, the theory predicts that share prices reflect the present value of the market’s expecta-
tions for future cash flows and dividends, which arise from expected future earnings. New information is important
because it can cause expectations to change, which can trigger changes in share prices. To isolate the new information in
earnings, we subtract the earnings that the market expected (and should have already impounded into price). For exam-
ple, suppose analysts and investors expect a firm will announce $3.00 EPS (earnings per share) this period.12 If the firm
announces that EPS are $4.00, then the new information is that the firm generated unexpected EPS of $1.00 this period.
The firm was more profitable than expected. Will this unexpected $1.00 of EPS cause investors and analysts to revise
expectations for future earnings? That depends on earnings persistence, which we consider next.
10
The theoretical framework we describe for the relation between earnings and share value is consistent with Ohlson (1995) and Feltham and Ohlson
(1995), which use the classical dividends-based valuation model to derive equivalent formal models of the links between earnings and share value.
These papers demonstrate that equity share value depends on book value of equity and forecasts of future “residual income,” which is comprehen-
sive income less a charge for the use of equity capital. These papers also demonstrate that the persistence of current period residual income is an
important determinant of share values. For additional discussion, see Bernard (1995) and Lee (1999) and most contemporary texts on financial
statement analysis-based valuation.
11
Some accounting researchers do conduct carefully controlled experimental studies that test psychology-based or economics-based theories about
how individuals (or groups of individuals in simulated market settings) use accounting information in decision-making. For a review of experimental
research in financial accounting, see Libby, Bloomfield, and Nelson (2002).
12
Researchers and investors often use consensus analysts’ earnings forecasts as proxies for the market’s earnings expectations. However, isolating the
new value-relevant information in earnings announcements has become more difficult over the past decade because firms have substantially
expanded the information released with earnings announcements, including bundling earnings guidance with earnings announcements (Baginski,
Campbell, Ryu, and Warren 2022) and filing Form 10-K on the earnings announcement day (Arif, Marshall, Schroeder, and Yohn 2019).
Accounting Horizons
Earnings Persistence
The third factor, earnings persistence, refers to the likelihood that a firm’s earnings level will be sustainable in future
periods, which is an essential element of step 2. If a firm generates persistent earnings, the market should expect the firm
to generate the same levels of earnings in future years. On the other hand, when a firm experiences unusually high or
low earnings in a given period because of transitory earnings components, such as one-time gains or losses, the market
would not expect such levels of earnings to recur in the future. For example, if a firm recognizes a one-time gain from
the sale of an asset this period, or a one-time loss from the settlement of a lawsuit this period, that transitory gain or loss
will not persist in future periods. Changes in earnings that are expected to persist trigger larger changes in share values
than do transitory earnings changes (Kormendi and Lipe 1987). We illustrate these differences in the numerical example
described later.
Market Efficiency
The fourth factor, market efficiency, refers to the scope of the information that share prices reflect and the degree to
which prices react quickly and completely (e.g., without bias, not under reacting or overreacting) to relevant new infor-
mation, such as unexpected earnings. Market efficiency does not assume that the capital markets are omniscient—prices
reflect only the information known to the market. Nor does market efficiency assume that prices are prescient—the
world is uncertain and surprises happen. Also, market efficiency is not an absolute; instead, it is a matter of degree,
which describes how much information prices reflect and how quickly prices react to new information and reach new
equilibrium levels. A highly efficient market with respect to accounting earnings should react quickly and completely to
all new earnings information as soon as it becomes available.13
Risk-Adjusted Stock Returns

Finally, expected returns models in financial economics predict that risky securities, such as shares of stock,
should provide a sufficient rate of return to compensate investors for forgoing consumption and bearing risk. As
one example, the capital asset pricing model (CAPM) predicts that equity securities will earn the risk-free rate of
return plus a risk premium that depends on the nondiversifiable risk of that security (i.e., beta) multiplied by the
average risk premium per unit of risk. An investor in a risky security should expect to earn a higher rate of return
from that security than from an investment in a less risky security. Thus, stocks should earn an expected rate of
return to compensate investors for forgoing consumption and bearing risk, separate from the change in share value
that is attributable to unexpected earnings news about the firm. Thus, researchers control for the expected
(“normal”) rate of return on each stock to isolate and detect the firm-specific “abnormal” return associated with
the firm’s unexpected earnings. A common approach is to subtract an expected rate of return on a stock from the
actual rate of return on the stock to measure the abnormal return. Researchers usually estimate expected returns
by using the CAPM, or a simple market-wide benchmark return (such as the return on the S&P 500 Index), or a
size-based benchmark return (historical returns data show smaller market capital firms tend to be riskier than
larger market capital firms).
A Numerical Example
Suppose a firm is expected to generate $3 EPS each year, trades at a share price of $30, and pays out 100 percent of
its earnings in dividends each year. This example implies the share trades at a price-to-earnings ratio of 10 ($30 price/$3
EPS) and is expected to generate a normal return of 10 percent ($3 EPS/$30 price). Let us consider how the share price
for this firm will react under three scenarios, as follows: (1) no unexpected earnings, (2) unexpected earnings that are
transitory, and (3) unexpected earnings that will persist.
No unexpected earnings. Suppose that the firm announces it generated $3 EPS this year, exactly meeting the mar-
ket’s expectations, and the market does not change its expectations for future earnings. In this scenario, the firm’s share
price will appreciate from $30 to $33 over the year due to the firm generating $3 EPS, exactly equivalent to the expected
return of 10 percent. When the firm pays the $3 dividend, the share price will return to $30. Because this firm this period
did not generate any unexpected earnings, the share would experience the normal expected returns of 10 percent, and
abnormal returns would be zero.
13
For an excellent discussion of market efficiency, see Lee (2001).
Accounting Horizons
Unexpected earnings that are transitory. Now, assume that the same firm announces $4 EPS at the end of the next
year, $1 higher than expected. Suppose the firm generated $3 EPS as expected and it generated the additional $1 EPS
because of a one-time gain this period. Because this one-time gain is transitory and will not persist, analysts and invest-
ors should not change their expectations for future earnings. The firm’s share price would appreciate from $30 to $33
over the year due to the firm generating the expected $3 EPS, which is exactly equal to the expected return of 10 percent.
But then the share price would increase by an additional $1 as soon as the firm announces the additional $1 EPS from
the one-time gain. Over the year, the share price would increase to $34 (because of the $3 expected EPS plus $1 unex-
pected EPS). The share would experience a 10 percent normal return ($3 expected EPS/$30 price) plus a 3.3 percent
abnormal return ($1 unexpected EPS/$30 price) due to the one-time gain. When the firm pays the $4 dividend, the share
price will return to $30. Because this firm this period generated unexpected earnings, the share would experience the nor-
mal expected returns plus the abnormal returns triggered by the unexpected earnings.14
Unexpected earnings that are persistent. Now, suppose instead that the firm announced $4 EPS because the firm
generated $3 EPS, as expected, and it generated the additional $1 EPS because of increases in revenues and decreases
in expenses that are likely to persist indefinitely in future periods. Because this increase in EPS is likely to persist, ana-
lysts and investors should increase their long-run expectations for future earnings for the firm. The market will now
expect the firm to generate $4 EPS and pay $4 in dividends every year in the future. In this scenario, the share price
will increase from $30 to $44 because of three effects. First, the share price will increase by $3 because the firm real-
ized the $3 expected EPS this year. The share would experience a 10 percent normal return ($3 expected EPS/$30
price). Second, because the firm generated $1 EPS above the market’s expectations this period, the share would also
experience a 3.3 percent abnormal return ($1 unexpected EPS/$30 price). Third, market participants would increase
their EPS expectations for all future years from $3 to $4. An additional $1 of expected future EPS in perpetuity has a
present value of $10, given an expected return of 10 percent. This is consistent with the market’s price-earnings multi-
ple of 10 for this firm. So the $1 increase in expected EPS for all future periods will cause the share price to increase
by an additional $10, which will trigger an additional 33.3 percent abnormal return ($10/$30 price). As a result of all
three effects, the share price would increase from $30 to $44 and then drop to $40 when the firm pays the $4 dividend.
The new $40 share price reflects $4 of expected future EPS each period, discounted to present value at the 10 percent
expected rate of return.15
In summary, theory provides a useful framework for predicting and testing the share price implications of earnings
information. Under this framework, share value reflects the present value of expected future cash flows and dividends,
which are determined by current and expected future earnings. When firms announce earnings that exactly meet the
market’s expectations, share prices typically experience normal, expected rates of return and no abnormal returns.
However, when firms announce earnings that differ from the market’s expectations, and if the market is reasonably effi-
cient, share prices should react to the earnings news. If earnings beat expectations, share prices should increase by the
normal expected rate of return and experience positive abnormal returns due to the unexpected earnings increase.
Likewise, if earnings fall short of the market’s expectations, share prices should increase by the normal expected rate of
return, but also experience negative abnormal returns due to the unexpected earnings decrease. How large is the impact
of unexpected earnings on share prices? That answer depends on many factors, including the persistence of the unex-
pected earnings. When a firm announces an unexpected change in earnings that will not persist, then abnormal returns
will simply be determined by the amount of the one-time unexpected earnings for that period. On the other hand, when
a firm announces an unexpected change in earnings that will persist in the future, abnormal returns will be much larger
amounts, determined by the unexpected earnings for the current period plus the present value of the change in expected
future earnings. How do we detect these price movements? We can detect them by examining abnormal stock returns
during specific periods of time when firms release new earnings information to the markets. Thus, when a firm
14
Suppose the firm generated $3 EPS as expected, but it generated an additional $1 EPS because of a one-time loss this period. The share price
would only increase to $32 (because of the $3 expected EPS $1 unexpected EPS). The share would experience a 10 percent normal return ($3
expected EPS/$30 price) minus a 3.3 percent abnormal return ($1 unexpected EPS/$30 price) due to the one-time loss.
15
Suppose instead that the firm did not generate $3 EPS as expected and only announced $2 EPS because of lower revenues and higher expenses that
are likely to persist indefinitely in future periods. Because this lower amount of EPS is likely to persist, analysts and investors should reduce their
expectations for future earnings for the long run of the firm. The market will now expect the firm to generate only $2 EPS and pay only $2 in divi-
dends every year in the future. The share would experience a 10 percent normal return ($3 expected EPS/$30 price) during the year. Because the firm
generated $1 EPS below the market’s expectations for the current year, the share would also experience a 3.3 percent abnormal return ($1
unexpected EPS/$30 price). In addition, the $1 decrease in expected EPS for all future periods will cause the share price to fall by an additional $10,
causing an additional 33.3 percent abnormal return ($10/$30 price). As a result of all three effects, the share price would increase from $30 to
$33 due to expected returns, and then drop to $22 ($33 $1 unexpected earnings for the current period $10 reduction in the present value of
future earnings). After the firm pays the $2 dividend, the new $20 share price will reflect $2 of expected future EPS each period, discounted to pre-
sent value at the 10 percent expected rate of return.
Accounting Horizons
announces earnings that differ from expectations (unexpected earnings), the theory provides a set of predictions about
the implications for future earnings and abnormal returns.
III. EVIDENCE LINKING EARNINGS AND STOCK RETURNS

In this section, we first describe the sample of firms, years, and data we use to conduct our tests. We then present
the results from our tests and their implications for the three steps in our framework described above. First, we report
the following two different sets of analyses that encompass all three steps: (a) associations between earnings and returns
and (b) market reactions to earnings announcements. Second, we provide evidence on each specific step. For step 1, we
examine earnings management around earnings benchmarks. For step 2, we examine whether share prices incorporate
richer information sets beyond current earnings and whether this information predicts future earnings (e.g., do current
period abnormal returns predict future earnings changes?). For step 3, we show that the opposite is also true. That is, in
some cases, current earnings information predicts future stock returns.
Sample Description
We examine samples of firms listed on the NYSE, AMEX, and NASDAQ exchanges during the period from 2002
to 2019. Our samples include all firms for which we can obtain the data we require for our tests from S&P Compustat
(financial statement data), the Center for Research in Security Prices (CRSP; stock prices and returns), and I/B/E/S (his-
torical analysts’ earnings forecasts, unadjusted for subsequent stock splits; Payne and Thomas 2003). Throughout our
analyses, we exclude firms with stock prices less than $1 and we exclude “microcap” stocks with market capitalizations
of less than $50 million. These firms generally have weaker information environments and lower degrees of stock price
efficiency. These firms comprise a relatively minor proportion of the market capitalization in public equity markets, but
the large numbers of these firms can unduly influence empirical results.
Table 1 reports two sets of descriptive statistics for our samples drawn from Compustat, CRSP, and I/B/E/S. Our
data requirements vary by test, so we do not maintain a constant sample across all analyses. For our tests of annual
earnings-returns associations, we use annual data from Compustat and CRSP, and our sample includes 43,827 firm-
year observations. We use quarterly earnings and forecast data from I/B/E/S in our earnings announcement tests,
post-earnings-announcement drift tests, and earnings distribution tests. This sample encompasses 150,540 firm-quarter
observations. The descriptive statistics in Table 1 suggest that our samples represent a wide range of different size firms,
from the relatively small to the very large. These statistics also indicate that, on average, these firms were generally prof-
itable and generated positive stock returns.
To isolate firm-specific abnormal returns, we control for the market-wide systematic risk factors that affect firms’
returns. Firm size (i.e., market capitalization) is a systematic risk factor with significant explanatory power for returns
(Banz 1981; Fama and French 1992; and others). We therefore compute abnormal returns as cumulative returns for
each firm minus the cumulative return to the CRSP size-decile portfolio to which the firm belongs. The research litera-
ture refers to this measure as a size-adjusted return because it controls for systematic market risk factors related to firm
size.
To What Extent Do Earnings Changes Relate to Stock Returns?

Our first analysis replicates the seminal work of Ball and Brown (1968). Does the sign of the change in annual earn-
ings covary with the sign of abnormal annual stock returns? Do firms with earnings increases (decreases) experience pos-
itive (negative) abnormal returns?
We group all sample firms each year into two portfolios, as follows: firms with positive and firms with negative
changes in income before extraordinary items.16 We cumulate abnormal stock returns experienced by each firm in each
portfolio each year beginning 11 months prior to and continuing through the month in which firms announce annual
earnings (month 0) until 6 months after the announcement. We summarize the results by averaging the cumulative
returns across all of the firms in each portfolio and across all 18 years in our sample period (2002–2019).
Table 2, Panel A presents the results. For the 12-month period from month –11 through month 0, the stocks of firms
with positive annual earnings changes experience average abnormal returns of 12.3 percent, whereas stocks of firms with
negative earnings changes experience average abnormal returns of –13.1 percent. These results are striking, suggesting
16
This measure simply excludes extraordinary items, which were rare transitory earnings components and are no longer recognized as such under
GAAP or IFRS.
Accounting Horizons
TABLE 1
Descriptive Statistics
Annual Earnings-Returns Sample Mean Std. Dev. 1st Quartile Median 3rd Quartile
Market capital ($MM) 5,520.57 24,403.91 210.06 680.56 2,538.73
Returns 0.13 0.66 0.24 0.05 0.36
Abnormal returns 0.01 0.59 0.30 0.05 0.21
Earnings ($MM) 241.53 1,549.99 10.50 16.12 103.50
Earnings changes ($MM) 17.14 899.65 13.51 2.51 27.34
Operating cash flows ($MM) 495.81 2,349.02 4.87 48.93 224.50
Operating cash flows changes ($MM) 29.42 620.21 14.12 2.35 31.48
EBITDA ($MM) 329.67 1,481.60 6.90 42.02 173.80
EBITDA changes ($MM) 15.05 713.14 4.91 2.34 19.44
Total assets ($MM) 4,886.38 23,034.61 184.40 627.02 2,393.91
n ¼ 43,827 firm-years for 5,806 firms
Quarterly Earnings-Returns Sample Mean Std. Dev. 1st Quartile Median 3rd Quartile
Market capital ($MM) 6,432.89 26,473.18 327.53 980.17 3,317.06
Returns 0.03 0.23 0.09 0.02 0.14
Abnormal returns 0.00 0.21 0.10 0.01 0.09
Earnings per share ($) 0.32 0.47 0.02 0.24 0.56
Unscaled unexpected earnings ($) 0.01 0.12 0.06 0.00 0.05
Unexpected earnings 0.00 0.01 0.00 0.00 0.00
n ¼ 150,540 firm-quarters for 6,075 firms
The annual earnings-returns sample includes 43,827 firm-year observations for NYSE, AMEX, and NASDAQ firms with statement of cash flows data
on quarterly Compustat for the period 2002–2019, prices greater than $1, and market values greater than $50 million as of the beginning of the fiscal year.
Variable Definitions:
Market capital ¼ number of shares outstanding times market price per share as of the end of the fiscal year;
Returns ¼ daily returns cumulated over the 12 months prior to and including the fourth quarter earnings announcement, where a month is defined
as 22 trading days;
Abnormal returns ¼ the cumulative raw returns described above less the cumulative returns over the same period to the size decile to which the
firm belongs;
Earnings ¼ income before extraordinary items, as reported on the statement of cash flows;
Earnings changes ¼ current year earnings – prior year earnings;
Operating cash flows ¼ cash flows from operating activities;
Operating cash flows changes ¼ current year operating cash flows – prior year operating cash flows;
EBITDA ¼ earnings before interest, taxes, depreciation, and amortization; and
EBITDA changes ¼ current year EBITDA – prior year EBITDA.
The quarterly earnings-returns sample includes 150,540 firm-quarter observations for calendar-year NYSE, AMEX, and NASDAQ firms with daily
returns data available on CRSP and historical analyst forecast data available on I/B/E/S (unadjusted for subsequent stock splits; Payne and Thomas
2003) from 2002 to 2019, prices greater than $1, and market values greater than $50 million as of 60 days before the earnings announcement.
Market capital ¼ number of shares outstanding times market price per share as of the end of the fiscal quarter;
Returns ¼ daily returns cumulated over the event period;
Event period ¼ the 60 trading days up to and including the date of the earnings announcement;
Abnormal returns ¼ the cumulative raw returns described above less the cumulative returns over the same period to the size decile to which the
firm belongs;
Earnings per share ¼ firm earnings per share as reported by I/B/E/S;
Unscaled unexpected earnings ¼ earnings per share as reported by I/B/E/S less the median forecast issued more than 60 but less than 90 days before
the earnings announcement; and
Unexpected earnings ¼ unscaled unexpected earnings described above divided by share price 60 days before the earnings announcement (for
cross-sectional comparability).
that merely the sign of the change in earnings is associated with an average difference of 25.4 percent in abnormal
annual stock returns.17 In comparison, Ball and Brown (1968) reported a difference of 16.8 percent based on differences
17
This difference is economically significant and statistically significantly different from zero (p < 0.001).
Accounting Horizons
TABLE 2
The Association between Annual Earnings Changes and Cumulative Abnormal Returns:
A Replication of Ball and Brown (1968)
Panel A: Positive and Negative Changes in Earnings and Positive and Negative Abnormal Returns
Cumulative Abnormal Cumulative Abnormal
Returns for Firms with: Returns for Firms with:
Months Positive Negative

Relative to Positive Negative Cumulative Cumulative
Earnings Changes in Changes in Abnormal Abnormal
Announcement Earnings Earnings Difference Returns Returns Difference
11 0.016 0.012 0.027 0.047 0.031 0.078
10 0.026 0.018 0.044 0.079 0.050 0.129
9 0.044 0.037 0.081 0.118 0.078 0.196
8 0.058 0.047 0.105 0.157 0.102 0.260
7 0.065 0.062 0.128 0.183 0.128 0.311
6 0.079 0.081 0.160 0.225 0.161 0.386
5 0.087 0.088 0.175 0.260 0.187 0.447
4 0.090 0.103 0.193 0.286 0.216 0.501
3 0.100 0.119 0.219 0.326 0.250 0.576
2 0.108 0.124 0.231 0.361 0.274 0.635
1 0.111 0.129 0.240 0.391 0.298 0.690
0 0.123 0.131 0.254*** 0.432 0.319 0.751***
1 0.132 0.137 0.269 0.440 0.322 0.762
2 0.139 0.140 0.279 0.450 0.324 0.774
3 0.137 0.136 0.273 0.449 0.324 0.773
4 0.142 0.136 0.278 0.459 0.326 0.784
5 0.142 0.139 0.281 0.459 0.328 0.787
6 0.138 0.136 0.274 0.456 0.328 0.784
(continued on next page)
in the sign of the change in earnings per share over their 1957–1965 sample period.18 These comparisons suggest that the
returns implications of earnings changes have increased since their sample period.19
To gauge the economic significance of these returns results, we also create portfolios based on perfect foresight of
the sign of abnormal returns (Francis and Schipper 1999). Specifically, we split our sample into two portfolios each year
based on perfect foresight of the sign of cumulative abnormal returns from month 11 to month 0 relative to the earn-
ings announcement. Cumulative abnormal returns to the positive (negative) returns portfolio average 43.2 percent
(31.9 percent) by month 0, which is a spread of 75.1 percent. Our results suggest that earnings changes are economi-
cally important pieces of information in the capital markets because simply knowing the sign of the earnings change
would allow investors to capture 33.8 percent (25.4 percent/75.1 percent) of the total information impounded in price on
average during the year.
18
Nichols and Wahlen (2004) report a spread in annual abnormal returns of 35.6 percent based on the differences in the sign of the change in earnings
over their 1988–2001 sample period.
19
In addition to different sample periods, our analysis differs from the Ball and Brown (1968) analysis in several ways. Thanks to modern databases
that were not available to Ball and Brown, we are able to use a broader set of sample firms and daily returns data to center the announcement month
around the earnings announcement date. Factors such as these could contribute to the differences we observe in the strength of the earnings-returns
association across the two studies.
Accounting Horizons
TABLE 2 (continued)
Panel B: Positive and Negative Changes in Earnings, Cash Flows from Operations, and EBITDA
Cumulative Abnormal Cumulative Abnormal Cumulative Abnormal
Returns for Firms with: Returns for Firms with: Returns for Firms with:
Accounting Horizons
Positive Negative
Months Changes in Changes in
Relative to Positive Negative Cash Cash Positive Negative

Earnings Changes in Changes in Flows from Flows from Changes in Changes in
Announcement Earnings Earnings Difference Operations Operations Difference EBITDA EBITDA Difference
11 0.016 0.012 0.027 0.010 0.003 0.013 0.007 0.001 0.005
10 0.026 0.018 0.044 0.017 0.005 0.021 0.014 0.000 0.014
9 0.044 0.037 0.081 0.030 0.017 0.047 0.025 0.007 0.032
8 0.058 0.047 0.105 0.042 0.023 0.065 0.036 0.009 0.045
7 0.065 0.062 0.128 0.046 0.034 0.081 0.039 0.018 0.057
6 0.079 0.081 0.160 0.056 0.047 0.104 0.050 0.029 0.079
5 0.087 0.088 0.175 0.064 0.054 0.118 0.057 0.033 0.090
4 0.090 0.103 0.193 0.065 0.066 0.131 0.060 0.044 0.104
3 0.100 0.119 0.219 0.072 0.077 0.149 0.068 0.055 0.123
2 0.108 0.124 0.231 0.079 0.080 0.159 0.075 0.057 0.131
The Essential Role of Accounting Information in the Capital Markets
1 0.111 0.129 0.240 0.081 0.084 0.165 0.079 0.061 0.140

0 0.123 0.131 0.254*** 0.093 0.085 0.177*** 0.092 0.062 0.154***
1 0.132 0.137 0.269 0.105 0.094 0.198 0.107 0.071 0.178
2 0.139 0.140 0.279 0.112 0.096 0.208 0.114 0.072 0.186
3 0.137 0.136 0.273 0.112 0.096 0.208 0.113 0.071 0.184
4 0.142 0.136 0.278 0.118 0.097 0.215 0.117 0.069 0.186
5 0.142 0.139 0.281 0.117 0.099 0.216 0.118 0.073 0.190
6 0.138 0.136 0.274 0.116 0.100 0.215 0.115 0.072 0.187
, , Denote statistical significance at the 10 percent, 5 percent, and 1 percent levels, respectively, in a two-tailed t-test.
The sample includes 43,827 firm-year observations for NYSE, AMEX, and NASDAQ firms with statement of cash flows data on quarterly Compustat for the period 2002–2019, prices
greater than $1, and market values greater than $50 million as of the beginning of the fiscal year. In Panel A, we sort firms into two portfolios each period based on positive or negative
changes in earnings and positive or negative future abnormal returns. In Panel B, we sort firms into two portfolios each period based on positive or negative changes in earnings, changes in
cash flows from operations, and changes in EBITDA. Month 0 (in bold) denotes the month of the annual earnings announcement.
Earnings ¼ income before extraordinary items as reported on the statement of cash flows;
Changes in earnings ¼ current period earnings – prior period earnings;
Changes in cash flows from operations ¼ current period operating cash flows – prior period operating cash flows;
EBITDA ¼ current period earnings before tax + interest expense + depreciation and amortization expense from the statement of cash flows;
Changes in EBITDA ¼ current period EBITDA – prior period EBITDA; and
Cumulative abnormal returns ¼ cumulative raw return – cumulative return to the size decile portfolio to which the firm belongs. The accumulation period starts 11 months before the earnings
announcement month.
117
How Do Changes in Other Firm Performance Measures Relate to Stock Returns?

Earnings reflect cash flows from operations adjusted for accounting accruals. Accruals shift the timing of revenue
and expense recognition from the period when cash flows are received or paid to the period of economic performance
(step 1). The purpose of accruals is to generate an earnings number that better reflects the economic accomplishments
and efforts during the period, rather than the mere inflows and outflows of cash. To highlight the value-relevant infor-
mation provided by accrual accounting, we compare the association between changes in earnings and abnormal returns
to the association between changes in cash flows from operations and abnormal returns. To conduct this comparative
analysis, we use exactly the same steps and sample firms, but we instead assign firms to portfolios based on the sign of
the change in annual cash flows from operations. The results in Table 2, Panel B and Figure 2 indicate that, for the 12-
month period from month –11 through month 0, firms with positive annual changes in cash flows from operations expe-
rience average abnormal returns of 9.3 percent, whereas firms with negative changes experience average abnormal
returns of –8.5 percent.20 These results suggest the sign of the changes in cash flows from operations is very informative
(an average returns spread of 17.7 percent), but the sign of the changes in earnings contains more value-relevant infor-
mation (an average returns spread of 25.4 percent). This occurs because, in part, changes in cash flows from operations
are more ambiguous measures of the firm’s wealth creation and profitability in a given period.21
We also examine the association between returns and an alternative measure of firm performance that has become
popular in practice, EBITDA. We again use exactly the same steps and sample firms, but now assign firms to portfolios
based on the sign of the change in annual EBITDA. The results in Table 2, Panel B and Figure 2 indicate that firms
with positive changes in EBITDA experience average annual abnormal returns of 9.2 percent, whereas firms with nega-
tive changes experience returns of 6.2 percent (an average returns difference of 15.4 percent). Together, the results
from these comparative analyses suggest that measures of performance based on cash flows or EBITDA are informative
and capture value-relevant information, but they are not nearly as informative as accounting earnings because they
exclude important value-relevant information measured in bottom-line earnings numbers.22
In additional analyses (not shown in tables and figures for brevity), we also examine how the magnitude of the
change in earnings is associated with stock returns. We first scale earnings changes by total assets at the beginning of the
year, and then we do the same for changes in cash flows from operations and EBITDA. We then rank the scaled changes
into deciles (e.g., top 10 percent, second 10 percent, and so forth) based on the distribution of scaled changes for the 12
months prior to the earnings announcement month of the firm. We form portfolios each year with the firms in the top
decile (largest increases) and bottom decile (largest decreases). We find that, for the period from month –11 through
month 0, the top decile firms with the biggest increases in annual earnings experienced average abnormal returns of 21.2
percent, whereas the bottom decile firms with the largest decreases in earnings experienced average abnormal returns of
–21.1 percent. These results reveal that extreme changes in earnings were associated with an average difference of 42.3
percent in abnormal annual returns.23 By comparison, extreme changes in cash flows from operations were associated
with a 35.4 percent difference in abnormal returns, and extreme changes in EBITDA were associated with a 29.2 percent
difference in abnormal returns.24
The evidence suggests that earnings numbers contain important information that relates to changes in the market’s
share prices, encompassing steps 1 through 3. The evidence also suggests that earnings reflect more value-relevant infor-
mation than other common measures of firm performance, such as changes in cash flows from operations or EBITDA
(step 1). Finally, this evidence reveals the potential value of investing based on accurate forecasts of the sign and
20
We also examine the association between returns and free cash flows to the firm. Free cash flows to the firm, defined as cash from operations minus
cash used for investing activities, reflects the cash generated during the period that is potentially available for distribution to debt and equity invest-
ors. Changes in free cash flows are also significantly associated with returns. For the 12-month period ending with the earnings announcement
month, firms with positive changes in free cash flows experience average abnormal returns of 10.2 percent, whereas firms with negative changes
experience average returns of 6.3 percent.
21
A change in cash flows from operations can be an ambiguous signal of firm performance in a given period. For example, a decrease in cash from
operations could signal good news (the firm used cash strategically to fund growth in inventory and receivables) or bad news (the firm had difficul-
ties in generating cash by not selling inventory or collecting receivables) during that period. An increase in cash from operations arises when a firm
generates greater cash flows from selling to customers and collecting receivables (good news) or from delaying payments to suppliers (bad news). In
contrast, increases and decreases in earnings are clearer signals of changes in profits during that period. Prior studies provide returns-based evidence
on the information in earnings versus cash flows, including Bowen, Burgstahler, and Daley (1987), Dechow (1994), and Sloan (1996).
22
Francis, Schipper, and Vincent (2003) also examine the explanatory power of earnings relative to alternative measures of performance and find con-
sistent results.
23
This difference is economically significant and statistically significantly different from zero (p < 0.001).
24
The return spread between extreme earnings changes and extreme cash flow changes is driven by the negative side. That is, stocks with extreme earn-
ings declines experience average returns of 21.1 percent, whereas stocks with extreme cash flow declines have returns of only 13.8 percent. When
bad news arrives, the accounting system recognizes it immediately, generally in the form of write-offs, impairment charges, or losses that reduce
earnings, but have little immediate cash flow effects. This is an example of how accrual accounting measures the value-relevant implications of trans-
actions and events (step 1) better than cash flows.
Accounting Horizons
FIGURE 2
Cumulative Abnormal Returns to Portfolios Sorted on Changes in Earnings, Changes in
Cash Flows from Operations (CFO), and Changes in EBITDA
magnitude of future earnings changes.25 This partly explains why so many investors and analysts devote so much time
and energy to forecasting earnings (step 2). In spite of the limitations of U.S. GAAP and IFRS and the potential for
25
As an extreme interpretation, suppose one could have forecasted merely the sign of firms’ earnings changes with perfect accuracy 12 months in advance.
Also suppose one could have formed portfolios then by taking long (short) positions in the firms with forecasted earnings increases (forecasted earnings
decreases). Those portfolios would have earned an average annual abnormal return of 25.4 percent over 2002–2019. Of course, this is unrealistic because it
is impossible to forecast earnings changes with perfect accuracy. But it shows the potential value to investing based on accurate earnings forecasts.
Accounting Horizons
earnings management (as discussed later), accounting earnings numbers appear to provide useful information about
firm value to the capital markets.
Do Earnings Numbers Convey New Information to the Market?

Capital market participants obtain information from a variety of sources, namely, analysts’ research reports, articles
in the financial press, company press releases and conference calls, to name a few. In addition, over the past decade,
firms have substantially expanded the information released with earnings announcements, including bundling earnings
guidance with earnings announcements (Baginski et al. 2022) and filing Form 10-K on the earnings announcement day
(Arif et al. 2019). This information helps investors develop expectations for future earnings that could preempt the earn-
ings announcement as a timely source of new information in capital markets. Therefore, the results in Table 2 provide
little evidence of whether earnings numbers provide new value-relevant information to the capital markets and whether
earnings announcements cause stock price reactions. To develop greater confidence that this is the case, we analyze price
reactions during days surrounding earnings announcements to assess whether and when earnings numbers convey new
information to the capital markets. Our sample for this analysis includes 150,540 firm-quarter observations, which are
described in Table 1.
We examine daily returns surrounding the day firms announce quarterly earnings, from four days before (day 4),
the day of the announcement (day 0), and through five days after (day +5). We sort stocks into ten portfolios based on
unexpected earnings for that quarter. We sharpen our measure of the new information in the earnings announcement by
calculating unexpected earnings as earnings per share minus the analysts’ consensus earnings per share forecast, divided
by price per share 60 trading days before the announcement. We measure the consensus analysts’ earnings per share
forecast as the median forecast issued by analysts between days 120 and 60 relative to the earnings announcement.
We group firms each quarter into 10 portfolios, ranging from the lowest decile to the highest decile of unexpected earn-
ings that quarter (the worst earnings news to the best earnings news).26
If earnings numbers convey new information that triggers the market to establish new share prices, then the sign
and magnitude of abnormal returns at the time of the earnings announcement should be associated with the sign and
magnitude of unexpected earnings. If firms announce earnings during market trading hours, prices can quickly adjust to
the new information revealed in the announcement, and the price reaction will (at least partially) occur on day 0. If firms
announce earnings after markets close, prices will adjust to the news on the following trading day, +1. In addition, finan-
cial press coverage following earnings announcements tends to occur on days 0 and +1. Thus, the market’s reactions to
the announcement should be concentrated in trading days 0 and +1.
We report the results in Table 3 and Figure 4. During day 0 through the end of day +1, Figure 4 reveals sharp
increases in abnormal returns for stocks announcing good earnings news and sharp decreases for stocks announcing bad
news. In particular, by the end of day +1, prices for the best earnings news stocks (decile 10) rose by an average of 4.0
percent, whereas prices for the worst earnings news stocks (decile 1) fell by an average of 3.8 percent. The difference in
returns through day +1 equals 7.7 percent and is strongly statistically significant. Of this 7.7 percent difference in reac-
tion, 7.0 percent occurs on days 0 and +1. To put this in context, consider that the average market capitalization of the
firms in this sample is $6,432.89 million. An average firm of that size in the top earnings news decile would experience a
$257.3 million increase in market value by day +1, whereas an average firm of that size in the bottom decile of earnings
news would experience a $244.4 million decline in market value by day +1, which is a difference of $501.7 million.
The evidence in this section has two important implications. First, the results suggest that earnings numbers convey
new information (step 1) that has important consequences for share prices. Second, the stock price consequences of new
earnings information reveal that market participants process (step 2) and trade (step 3) on that information quickly—
stock prices react quickly and incorporate most of the new information by the end of day +1.
To What Extent Do Prices Lead Earnings?

Taking a step further, to what extent does the information impounded in share prices predict future earnings beyond
the current year? Table 2 showed that earnings changes capture roughly one-third of the value-relevant information
impounded in prices each year. However, the earnings number for a single period is subject to limitations as a measure
of performance, as governed by the applications of accounting principles. Recognition and measurement of revenues
and expenses and the corresponding assets and liabilities occur with incomplete information and require estimation and
judgment. Thus, although the information reflected in earnings for a single period is a limited subset of the value-relevant
26
To sort firms into decile portfolios without foresight bias, we use decile breakpoints from all earnings announcements for the three months prior to
the month of the earnings announcement.
Accounting Horizons
TABLE 3
Cumulative Abnormal Returns during the Ten Days Surrounding Earnings Announcements
Cumulative Abnormal Returns for Unexpected Earnings (UE) Decile Portfolios

Days Relative Highest
to Earnings Lowest Highest Minus
Announcement UE 2 3 4 5 6 7 8 9 UE Lowest
4 0.001 0.001 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.001 0.002
3 0.002 0.001 0.000 0.001 0.000 0.000 0.001 0.000 0.001 0.002 0.003
2 0.002 0.002 0.001 0.001 0.000 0.001 0.002 0.001 0.002 0.003 0.005
1 0.002 0.002 0.001 0.000 0.000 0.002 0.002 0.002 0.003 0.005 0.007
0 0.017 0.011 0.008 0.005 0.002 0.003 0.007 0.011 0.017 0.021 0.037***
1 0.038 0.025 0.019 0.013 0.006 0.004 0.013 0.023 0.033 0.040 0.077***
2 0.039 0.026 0.019 0.013 0.007 0.004 0.012 0.023 0.034 0.042 0.081
3 0.040 0.026 0.019 0.013 0.007 0.003 0.012 0.023 0.034 0.044 0.084
4 0.041 0.027 0.019 0.013 0.007 0.003 0.012 0.023 0.035 0.045 0.086
5 0.041 0.026 0.019 0.013 0.007 0.003 0.012 0.023 0.035 0.047 0.088
The sample for this table and Figure 3 includes 150,540 firm-quarter observations for calendar-year NYSE, AMEX, and NASDAQ firms with
daily returns data available on CRSP and analyst forecast data available on I/B/E/S from 2002–2019, prices greater than $1, and market values
greater than $50 million as of 60 days before the earnings announcement. We rank firms into deciles each quarter based on unexpected earnings.
Days 0 and 1 (in bold) denote the earnings announcement day and the day following the earnings announcement.
Unexpected earnings (UE ) ¼ earnings per share as reported by I/B/E/S less the median analysts’ earnings forecast issued more than 60 but less than 120
days before the earnings announcement divided by share price 60 days before the earnings announcement (for cross-sectional comparability); and
Cumulative abnormal returns ¼ cumulative raw return minus the cumulative return to the size decile to which the firm belongs. The accumulation
period begins four days before the earnings announcement.
information, the information impounded into price is not similarly constrained. Market prices can incorporate all value-
relevant information about firm performance.
To what extent does the additional two-thirds of the information impounded in share values (steps 2 and 3) predict
future earnings? To address this question, we formed portfolios each year using a nested sort procedure. We first sorted
firms into quintiles by current year earnings changes (scaled by total assets). Next, within each earnings change quintile,
we sorted firms into deciles by contemporaneous abnormal returns. Finally, we measured average one-year-ahead earn-
ings changes (scaled by total assets) for each abnormal returns decile portfolio. This procedure allows current period
returns to vary while controlling for current period earnings changes.
Controlling for current period earnings changes, the results in Table 4 and Figure 4 show that current period stock
returns predict earnings changes in year +1. On average, the firms in the highest abnormal returns decile in the current
year generated earnings (as a percent of total assets) that were 1.1 percent higher in year +1 than those in the current
year. Firms in the lowest abnormal returns decile in the current year generated earnings (as a percent of total assets) that
were 1.0 percent lower in year +1 than those in the current year. Given that the median rate of return on assets
(roughly speaking, earnings divided by total assets) equals 3.5 percent for firms in our sample, these results suggest that
current period stock returns predict significant differences in return on assets one year ahead. Stock returns during the
current year not only reflect current year earnings news but also predict changes in earnings next year.27
IV. EVIDENCE ON SLIPPAGE IN THE THREE STEPS LINKING FIRMS’

BUSINESS ACTIVITIES TO SHARE PRICES
To summarize the results thus far, the transactions and events that drive earnings higher or lower also drive stock
prices higher or lower. Perfect foresight of the sign of the change in earnings captures on average roughly one-third of
the returns achievable by forming portfolios based on perfect foresight of the sign of abnormal returns. Changes in
27
Prior research documents that prices reflect information before it appears in accounting earnings. Seminal studies examining the information content
of security prices include Beaver, Lambert, and Morse (1980) and Beaver, Lambert, and Ryan (1987).
Accounting Horizons
FIGURE 3
Cumulative Abnormal Returns to Portfolios Sorted on Earnings Surprises
earnings capture more value-relevant information than changes in cash from operations or EBITDA. In addition, firms’
earnings announcements provide new information that triggers significant changes in price. Finally, a portion of the
additional information impounded in price during the current year also predicts significant increases and decreases in
earnings one year ahead. The results to this point indicate that the three steps linking business activities to financial
reports to share values and prices operate well, but do not completely explain share prices or stock returns. Next, we
examine possible sources of slippage in each of the three steps in more detail.
Accounting Horizons
FIGURE 4
Difference in Year +1 Earnings Changes between High and Low Year 0 CAR Portfolios,
Controlling for Year 0 Earnings Changes
Do Managers Influence the Earnings Reporting Process?

Graham, Harvey, and Rajgopal (2005) surveyed top-level managers at publicly traded companies. The managers
confirmed that they view earnings as the most important measure of firm performance communicated to parties outside
the firm. They also described the benefits of meeting and the adverse consequences of missing earnings benchmarks.
Among the benefits, managers mentioned increased stock prices, more credibility, and a better reputation of the manag-
ers. Adverse consequences of missing earnings benchmarks included lower stock prices, higher uncertainty, and the con-
cern by outsiders that previously unknown problems exist within the company.
Managers may be concerned about meeting or beating three natural earnings benchmarks. In accounting research,
analysts’ earnings forecasts are common proxies for the market’s expectations for firms’ earnings. This benchmark is
salient to managers because it reflects the level of earnings that analysts expect the firm to generate to justify the current
share price (Degeorge et al. 1999). Other prominent benchmarks include reporting positive earnings, indicating the com-
pany turned a profit for the common shareholders, as well as meeting or beating last year’s earnings, indicating that the
company’s performance improved (Burgstahler and Dichev 1997).
If the underlying business performance is falling a little short of the benchmark, some managers might resort to manag-
ing earnings upward to meet or beat the benchmark.28 Accounting requires managers to make many estimates and
28
In addition, some managers will also guide analysts to “walk down” their earnings forecasts to lower levels that managers believe they can achieve
(Matsumoto 2002).
Accounting Horizons
TABLE 4
Year +1 Earnings Changes (Scaled by Total Assets) for Portfolios of Firms with the Highest and Lowest Cumulative
Abnormal Returns in the Current Year, after Controlling for Current Year Earnings Changes
Year +1 Earnings Year +1 Earnings

Changes among Changes among
Firms with the Firms with the
Lowest Year 0 Highest Year 0
Year Cum. Ab. Returns Cum. Ab. Returns Difference
2002 0.082 0.056 0.025
2003 0.002 0.042 0.044
2004 0.015 0.025 0.040
2005 0.022 0.022 0.044
2006 0.002 0.005 0.007
2007 0.049 0.006 0.055
2008 0.013 0.016 0.003
2009 0.037 0.067 0.030
2010 0.023 0.038 0.061
2011 0.054 0.014 0.068
2012 0.016 0.009 0.007
2013 0.006 0.014 0.008
2014 0.077 0.025 0.052
2015 0.013 0.001 0.012
2016 0.019 0.016 0.003
2017 0.024 0.036 0.013
2018 0.020 0.032 0.012
Average 0.010 0.011 0.021
, , Denote statistical significance at the 10 percent, 5 percent, and 1 percent level, respectively, in a two-tailed t-test.
The sample includes 40,840 firm-year observations for NYSE, AMEX, and NASDAQ firms with statement of cash flows data on quarterly
Compustat for the period 2002–2018; stock prices greater than $1; and market values greater than $50 million as of the beginning of the fiscal year.
Each year, we first sort firms into quintile portfolios by the year 0 earnings change (scaled by year 1 total assets). We then further sort each portfolio
into decile portfolios by the year 0 cumulative abnormal return (CAR). We report the year +1 earnings change (scaled by year 0 total assets) for the
highest and lowest CAR portfolios. This procedure allows us to capture variation in year 0 CAR while controlling for year 0 earnings changes.
Earnings ¼ income before extraordinary items as reported on the statement of cash flows;
Earnings changes ¼ current period earnings – prior period earnings; and
Cumulative abnormal returns (Cum. Ab. Returns) ¼ cumulative raw return – cumulative return to the size decile portfolio to which the firm
belongs. The accumulation period starts 11 months before the earnings announcement month.
judgments, providing mechanisms (e.g., accelerating revenues or delaying expenses) some managers might use to increase
reported earnings to hit benchmarks. Some managers may even alter real activities to reach earnings benchmarks, such as
cutting advertising and research and development expenses (Roychowdhury 2006). If managers engage in these activities, the
distribution of earnings should exhibit unusual behavior around common benchmarks; too many observations should appear
just above the benchmark and too few observations should appear just below the benchmark.29
The costs of managing the earnings have increased over time as regulators have taken a harder stance on earnings
management in the wake of accounting scandals such as Enron, Worldcom, and others. For example, the SEC issued
Staff Accounting Bulletin 99 (SAB 99) to address earnings management concerns. SAB 99 deems any accounting error
material if the error allowed the firm to reach any one of the three earnings benchmarks mentioned above.
Consequently, it is not clear whether the early evidence on earnings management around benchmarks will persist into
later periods.
29
Financial statement users’ concerns should also extend to the potential management of reported cash flows. Indeed, it is much simpler for managers
to manipulate reported cash flows than earnings. For example, to report greater cash flows from operations in a particular period, the managers can
take a number of steps (which do not violate GAAP), such as delaying paying payables, delaying certain expenses like advertising, providing credit
customers incentives to pay receivables early, or simply waiting to cut checks for cash payments until immediately after the end of the period.
Accounting Horizons
To examine how reported earnings numbers relate to analysts’ earnings forecasts as a benchmark, we examine the
distribution of analysts’ earnings forecast errors around zero, replicating Degeorge et al. (1999). We measure forecast
error by subtracting the analysts’ consensus quarterly earnings forecast from the reported quarterly earnings per share.
We then divide the analysts’ forecast error by share price 60 days before the earnings announcement. (This is the same
unexpected earnings variable we used in our earnings announcement tests reported in Table 3.) Next, we place the obser-
vations into bins of narrow width (for example, 0.5 percent increments) based on the value of the scaled earnings fore-
cast error. Finally, we count the number of observations in each bin and plot the frequency in Figure 5. The darkly
shaded areas above and below the x-axis report the number of observations in each bin that are above or below the num-
ber of observations in the corresponding bin on the opposite side of the distribution. Notice the striking amount of
darkly shaded areas just above zero and just below zero on the x-axis—many more firms than expected report earnings
that just beat analysts’ forecasts, and many fewer firms than expected report earnings just below analysts’ forecasts.
These statistics provide circumstantial evidence to suggest that firms manage earnings to meet or beat analysts’ earnings
forecasts.30
In additional analyses (not shown in tables or figures), we also examined earnings management to show a profit and
to beat prior year earnings. We found that significantly more (fewer) observations than expected report small profits
(losses). We found mixed evidence on earnings management to beat prior year’s earnings. We did not observe an unusu-
ally low number of firms reporting a small earnings decline, but we did find an unusually high number of firms reporting
a small earnings increase.
Although the evidence supports earnings management around these benchmarks, the results are substantially
weaker than those reported in the original studies. As Burgstahler and Chuk (2015, 2017) note, our sample period is
characterized by greater degrees of regulatory attention focused on earnings management and greater consequences to
managers who are caught cooking the books. One possible explanation (which we do not test) for our results is that
changes in the regulatory and legal environment have diminished (but not eliminated) managers’ propensity to engage
in earnings management behavior around these benchmarks. Also, another possible explanation noted earlier is that
greater numbers of firms are increasingly reporting non-GAAP performance measures, so perhaps managers are less
concerned about meeting or beating GAAP-based earnings benchmarks.
How Efficiently Does the Market Impound Earnings News into Share Prices?
The efficient markets hypothesis predicts that prices will incorporate the implications of the new information
in earnings announcements quickly, completely, and without bias. The stock price consequences of new earnings
information suggest that capital market participants have incentives to efficiently use all available information to
predict earnings. That is, investors have incentives to forecast which firms are more or less likely to experience
future earnings changes and form portfolios that take long (short) positions in firms expected to announce earnings
increases (decreases) prior to earnings announcements. In anticipating changes in earnings before they are
announced, investors can use various sources of information, including current period earnings news, managers’
disclosures of earnings guidance, analysts’ earnings forecasts, and economic indicators. In addition, market partici-
pants have incentives to react completely once firms announce earnings, such that no abnormal returns can be
earned consistently on earnings information after it is publicly available. However, slippage in step 2 could occur
if (at least some) investors do not quickly impound all of the new value-relevant earnings information into their
assessment of share value. Also, market frictions, such as liquidity constraints, transaction costs, and short sale
constraints, could hinder the trading activities necessary to fully incorporate the revised value estimates into price
(slippage in step 3).
Our next analysis extends the seminal work of Bernard and Thomas (1989, 1990), which examines the effi-
ciency with which market prices anticipate earnings news and the completeness with which prices react to earnings
news. Their results reveal that share prices are quite efficient in anticipating and pricing earnings news over the 60
trading days prior to the earnings announcement (steps 2 and 3). However, their results also show the market’s
reactions to quarterly earnings news are not complete. Over the 60 trading days following earnings announce-
ments, stock prices continue to drift up (down) for the firms with the best (worst) earnings news announcements,
suggesting the capital markets were not perfectly efficient in reacting quickly to earnings surprises (slippage in
steps 2 and 3).
30
We use the statistic developed in Degeorge et al. (1999) to test whether the proportion of observations just meeting or beating the forecast is larger
than expected based on the characteristics of the distribution and the surrounding bins.
Accounting Horizons
FIGURE 5
Histogram of Forecast Error for Earnings per Share
The tau (s) statistic tests whether the slope of the distribution immediately below bin 0 is different from the slope of the distribution immediately
above bin 0. The distribution of the tau statistic approximates at t-distribution. See Degeorge et al. (1999) for more information.
Major innovations in technology over the decades since the Bernard and Thomas study period have acceler-
ated the dissemination of earnings information and reduced the costs to acquire and process that information. The
capital markets have also developed advances in the speed and efficiency of share trading activities. In addition,
sophisticated market participants should be aware of the potential to earn excess returns following earnings
announcements. Have these developments and incentives enhanced the degree of market efficiency with respect to
earnings information?
To address this question, we use the same 10 earnings news portfolios each quarter (grouped from best decile to
worst decile earnings news) from our earnings announcement tests in Figure 3 and Table 3. As soon as a firm announces
Accounting Horizons
TABLE 5
Cumulative Abnormal Returns during the 60 Trading Days before and after Earnings Announcements
Cumulative Abnormal Returns for Unexpected Earnings (UE ) Decile Portfolios

Days Relative Highest
To Earnings Lowest Highest Minus
Announcement UE 2 3 4 5 6 7 8 9 UE Lowest
55 0.005 0.003 0.002 0.001 0.000 0.001 0.002 0.004 0.006 0.007 0.012
50 0.007 0.004 0.001 0.001 0.001 0.003 0.004 0.006 0.010 0.012 0.019
45 0.009 0.007 0.003 0.002 0.001 0.004 0.005 0.010 0.014 0.019 0.028
40 0.012 0.009 0.004 0.004 0.001 0.004 0.006 0.012 0.018 0.026 0.038
35 0.015 0.011 0.005 0.004 0.001 0.005 0.007 0.014 0.021 0.032 0.046
30 0.020 0.014 0.007 0.005 0.001 0.005 0.008 0.014 0.022 0.033 0.053
25 0.026 0.017 0.009 0.006 0.001 0.005 0.009 0.017 0.025 0.036 0.062
20 0.030 0.020 0.013 0.008 0.000 0.004 0.009 0.018 0.027 0.039 0.069
15 0.035 0.022 0.015 0.009 0.002 0.005 0.010 0.019 0.030 0.044 0.080
10 0.040 0.024 0.017 0.011 0.003 0.005 0.011 0.021 0.032 0.048 0.088
5 0.045 0.027 0.019 0.011 0.003 0.006 0.012 0.022 0.035 0.052 0.097
0 0.062 0.038 0.027 0.017 0.005 0.009 0.019 0.033 0.052 0.073 0.135***
0 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
5 0.004 0.001 0.000 0.000 0.000 0.001 0.001 0.000 0.002 0.006 0.011
10 0.006 0.000 0.001 0.001 0.000 0.000 0.000 0.000 0.003 0.009 0.015
15 0.005 0.000 0.002 0.002 0.001 0.001 0.001 0.000 0.004 0.011 0.016
20 0.006 0.000 0.003 0.002 0.002 0.002 0.002 0.002 0.005 0.014 0.020
25 0.004 0.001 0.005 0.003 0.002 0.002 0.002 0.002 0.005 0.016 0.020
30 0.001 0.002 0.006 0.003 0.003 0.003 0.003 0.002 0.006 0.016 0.017
35 0.001 0.002 0.006 0.003 0.003 0.003 0.003 0.003 0.007 0.018 0.018
40 0.001 0.001 0.006 0.002 0.002 0.004 0.003 0.002 0.008 0.019 0.020
45 0.003 0.001 0.005 0.001 0.001 0.004 0.003 0.002 0.008 0.020 0.023
50 0.005 0.000 0.004 0.001 0.001 0.003 0.003 0.002 0.008 0.022 0.027
55 0.008 0.001 0.003 0.001 0.000 0.003 0.004 0.003 0.008 0.021 0.029
60 0.009 0.003 0.003 0.001 0.000 0.004 0.004 0.003 0.008 0.021 0.030
The sample includes 150,540 firm-quarter observations for calendar-year NYSE, AMEX, and NASDAQ firms with daily returns data available
on CRSP and analyst forecast data available on I/B/E/S from 2002–2019, prices greater than $1, and market values greater than $50 million as of
60 days before the earnings announcement. We rank firms into deciles each quarter based on unexpected earnings. Day 0 (in bold) denotes the
earnings announcement day.
Unexpected earnings (UE) ¼ earnings per share as reported by I/B/E/S less the median analysts’ earnings forecast issued more than 60 but less
than 120 days before the earnings announcement divided by share price 60 days before the earnings announcement (for cross-sectional compa-
rability); and
Cumulative abnormal returns ¼ cumulative raw return minus the cumulative return to the size decile to which the firm belongs. The pre-
announcement accumulation period begins 60 days before and continues until the day of the earnings announcement. The post-announcement
cumulation period begins on the day after the earnings announcement and continues through day +60 after the announcement.
earnings for a quarter, we add that stock to a portfolio based on the earnings news.31 Following Bernard and Thomas,
we cumulate daily returns over 60 trading days before and 60 trading days after the earnings announcement. Daily
returns over the preannouncement period (from day 60 to 1) reflect the arrival of information prior to the earnings
announcement (day 0) that aids investors in predicting the sign and magnitude of the earnings news (step 2).
31
We measure earnings news using analyst forecast errors. Because we measure analysts’ earnings forecasts at least trading 60 days prior to the earn-
ings announcement, the forecasts should reflect the market’s expectations as of day 60.
Accounting Horizons
Immediately after the day of the earnings announcement, we begin cumulating returns from zero again for each of
our 10 portfolios each quarter. This is equivalent to forming 10 portfolios each quarter based on the earnings news
announced the day before (again, best news decile to worst news decile). If the market is fully efficient with respect to
quarterly earnings information, then share prices should quickly and completely impound the earnings information at
the announcement date, and we should not observe any consistently significant abnormal returns in the postannounce-
ment period.
We summarize each decile portfolio’s stock return performance by averaging the abnormal returns for the firms in
each decile each quarter. We then average each decile’s return across the 72 quarters in our sample (quarter 1 (Q1) 2002
through Q4 2019). Our sample for this analysis includes 150,540 firm-quarter observations, described in Table 1. We
present the results in Table 5 and Figure 6.
Does the capital market anticipate the information in quarterly earnings announcements? The preannouncement
portfolio returns indicate that the answer is yes. Beginning 60 trading days prior to and continuing through the day of
quarterly earnings announcements (day 0), abnormal returns move significantly with the sign and magnitude of quar-
terly unexpected earnings. The results in the top half of Table 5 and the left side of Figure 6 show that by the end of day
0, the lowest unexpected earnings portfolio has suffered an average abnormal return of –6.2 percent, whereas the highest
unexpected earnings portfolio has enjoyed an average abnormal return of 7.3 percent. This is a difference of 13.5 percent
in returns in only 60 trading days.32 (This preannouncement returns spread is somewhat larger than the 10.4 percent
observed in Bernard and Thomas 1989). The average abnormal returns increase monotonically across the 10 unexpected
earnings decile portfolios. During the 59 days leading up to the day of the earnings announcement, the markets may be
receiving information to help predict the upcoming earnings news, including revisions in analysts’ forecasts, manage-
ment forecasts (or other earnings-related disclosures), earnings announcements from peer and competitor firms, and
other useful information. The evidence depicted on the left-hand side of Figure 6 presents a striking picture of a market
that anticipates and reacts quickly to quarterly earnings information.
Are stock returns after earnings announcements related to the “old” earnings surprise? The postannouncement
stock returns indicate that the answer is again yes. The results depicted on the right-hand side of Figure 6 and the
bottom half of Table 5 reveal that stock returns to the decile portfolios continue to drift in the direction of the
earnings news. By day +60 after the earnings announcement, the lowest-decile portfolio experienced average abnor-
mal returns of 0.9 percent, whereas the highest decile enjoyed abnormal returns of 2.1 percent. The spread is 3.0
percent and is statistically significant, but smaller than the roughly 4.2 percent spread observed in Bernard and
Thomas (1989). The results suggest that market prices reflect extreme earnings news with a delay. The postan-
nouncement period is tradable because portfolios are formed based on earnings news that is publicly available.
Thus, in principle, the returns observed from day +1 to +60 can potentially be realized (net of transactions costs)
by traders.
Firms with larger market capitalization tend to have more sophisticated investors and more institutional
investors, are covered by larger numbers of analysts, receive more press coverage, and provide more earnings guid-
ance than smaller firms. Does the market react to and price earnings information more efficiently for larger firms
than for smaller firms? To address this question, we repeat the analysis reported in Table 5 for the 30 percent of
firms with the largest market capital (large-cap stocks) and the 30 percent of the firms with the smallest market
capital (small-cap stocks). For large-cap stocks, the average difference in post-earnings-announcement returns
(from day +1 to day +60) between the best and worst earnings news firms averaged only 1.9 percent (results not
tabulated). The market appears to be less efficient in reacting to earnings information for small-cap stocks because
the average difference in post-earnings-announcement returns between the best and worst earnings news firms aver-
aged 3.6 percent.
Overall, the results in Tables 4 and 5 suggest that capital markets are highly efficient with respect to earnings news,
but not yet fully efficient, particularly when small-cap and mid-cap firms announce extremely good or extremely poor
earnings news. This phenomenon has become known as “post-earnings-announcement drift,” and it remains one of the
most puzzling anomalies in tests of the degree of capital market efficiency with respect to earnings information.33
32
The returns over this period do not represent an implementable trading strategy because we form portfolios at day 60 by using information that
firms will reveal 60 days later at the subsequent earnings announcement.
33
Bernard and Thomas (1990) show very compelling results suggesting that markets react to earnings surprises with a naive earnings expectations
model, enabling predictions of significant abnormal returns during short windows around the next quarters’ earnings announcements. Post-earn-
ings-announcement drift has been tested against a host of widely established risk-based asset pricing models, against various models for quarterly
earnings expectations, against market frictions like transactions costs, and across firms of different sizes, on different exchanges, and in different
countries. To date, none of these tests has produced a rational explanation for post-earnings-announcement drift.
Accounting Horizons
FIGURE 6
Cumulative Abnormal Returns to Portfolios Sorted on Earnings Surprises
However, contrasting our results with those in Bernard and Thomas (1989) indicates that preannouncement returns
have increased and post-earnings-announcement returns have diminished in recent periods. The evidence points to the
possibility that, in a highly efficient market with substantial incentives to exploit this anomaly, share prices have
become more efficient with respect to quarterly earnings news. However, the evidence suggests that share prices for
small-market-capital stocks still react with some delay to extreme quarterly unexpected earnings, reflecting slippage in
step 2 and/or step 3.
Accounting Horizons
V. CONCLUSION
Accounting scholars have been studying the capital market consequences of financial accounting information for
decades, revealing some important insights into the complex and dynamic relations between accounting information
and stock returns. In recent decades, a number of fundamental changes have occurred in the accounting information
environment, including more firms reporting non-GAAP performance measures and substantially more frequent share
trading based on signals that are not tied to firm-specific accounting information (e.g., algorithmic trading and
exchange-traded funds). Several studies also suggest that perhaps the value relevance of accounting information, and
earnings in particular, has deteriorated over the past two decades, in part because of the increasing use of intellectual
property and intangible assets that may not be faithfully represented in firms’ financial statements. To what extent do
the results from seminal studies of accounting information still hold?
We use data from 2002 to 2019 to contribute updated empirical evidence on the extent to which some of the key
results still hold. Despite the many changes occurring in financial reporting, the capital markets, and securities regula-
tion, our evidence shows that changes in earnings still remain strongly associated with stock returns and are associated
with roughly one-third of the information impounded in share prices each year. In addition, we show that earnings con-
vey more information than cash flows from operations and non-GAAP performance measures such as EBITDA.
Furthermore, we demonstrate that market prices react to earnings news very quickly in days around earnings announce-
ments. We also find that stock returns continue to convey a lot of information about one-year-ahead earnings, beyond
the information in current period earnings. We also contribute updated evidence that indicates managers still intervene
in the earnings reporting process to manage earnings upward to just meet or beat earnings benchmarks, but this behav-
ior has diminished considerably since the original studies, perhaps due to more disciplined auditing and corporate gover-
nance, as well as tighter securities regulation. Moreover, we find that market prices have become more efficient in
pricing quarterly earnings news, but prices are not yet completely efficient, particularly for mid-cap and small-cap
stocks. Our evidence shows that the associations between earnings and stock returns remain robust and explain (in part)
why investors, managers, boards of directors, analysts, the financial press, auditors, securities regulators, and others con-
tinue to place so much importance on accounting information.
This paper uses a straightforward three-step framework to map firms’ business activities into share prices and pro-
vides a brief introduction to the research methods and empirical evidence on the role of accounting information in the
capital markets. This paper enables accounting and finance students, practitioners, instructors, and others to gain a
deeper understanding of the important consequences of earnings and accounting information in the capital markets.
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ACCOUNTING HORIZONS American Accounting Association

Vol. 37, No. 2 DOI: 10.2308/HORIZONS-18-075

The Essential Role of Accounting Information in the

Submitted: November 2021

II. THE RELATION BETWEEN BUSINESS ACTIVITIES AND SHARE PRICES

How Do Business Activities Relate to Share Prices?

Step 1: Financial Reporting

Firms’ Business Activities

Step 1: The Financial Reporting Process

Step 2: The Analysis and Valuation Process

Step 3: The Share Trading and Pricing Process

(The full-color version is available online.)

Step 2: Analysis and Valuation

Step 3: Share Trading and Pricing

How Do We Test the Relation between Earnings and Stock Returns?

Earnings Expectations and Unexpected Earnings

Risk-Adjusted Stock Returns

III. EVIDENCE LINKING EARNINGS AND STOCK RETURNS

To What Extent Do Earnings Changes Relate to Stock Returns?

Months Positive Negative

(continued on next page)

Volume 37, Number 2, 2023

1 0.111 0.129 0.240 0.081 0.084 0.165 0.079 0.061 0.140

How Do Changes in Other Firm Performance Measures Relate to Stock Returns?

(The full-color version is available online.)

Do Earnings Numbers Convey New Information to the Market?

To What Extent Do Prices Lead Earnings?

Cumulative Abnormal Returns for Unexpected Earnings (UE) Decile Portfolios

IV. EVIDENCE ON SLIPPAGE IN THE THREE STEPS LINKING FIRMS’

(The full-color version is available online.)

(The full-color version is available online.)

Do Managers Influence the Earnings Reporting Process?

Year +1 Earnings Year +1 Earnings

Cumulative Abnormal Returns for Unexpected Earnings (UE ) Decile Portfolios

(The full-color version is available online.)

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