1 Discussion of “Does the stock market see a zero or small positive earnings surprise as a red flag?” Zhihong CHEN Department of Accountancy The City University of Hong Kong

2 Summary of Findings Investigate whether investors and analysts see zero or small positive earnings surprise (MBE) as indicator of earnings management. ERC is significant lower for MBE firms in late 1990s and early 2000s but not in early 1990s. AERC is insignificant in early 1990s and significantly negative in late 1990s and early 2000s for MBE firms. MBE firms are associated with lower than expected returns in the post-earnings-announcement period.

3 Motivation and Contribution What is the Null Hypothesis? –Investors may rely on zero or small positive earnings surprise to identify earnings management. Academic research suggests that firms manipulate earnings and/or expectations to meet or beat earnings target. It is difficult for investors to detect earnings manipulation. Looking at forecasts trajectory is not reliable. –Why investors may not rely on such subtle clues? –Why do we need an empirical test without a credible null hypothesis? Link to the existing literature? –Investors’ response is key knowledge to understand firms’ behavior. –May provide more discussion of prior literature (e.g., Bartov et al. (2002, JAE), Brown and Caylor (2005, TAR)).

4 Research Design Use IBES Detail File –Precise proxy for earnings expectation –Use preannouncement period CAR to proxy for expectation change may not be enough –Marginal cost of using detail file is not high Regression Specification –CAR (FREV) = a + b*D*ES/P + c*Control*ES/P + e –Dummies for SE ranges and control variables should be included in the intercept –Forcing intercepts identical may inflate slop estimates for observations with larger magnitude of ES/P. The rationale of using [-1,0) as benchmark? –Firms unable to meet earnings expectation may be perceived as having big trouble (Graham et al. (2004)) Confounding events during –To what extent the results are driven by bubble (burst) in this period?

5 Several Related Issues Are skepticisms of investors and analysts justified? –Declining ERC and AERC are associated with increasing frequency of zero or small positive earnings surprise. –Increasing frequency of zero or small positive earnings surprise does not necessarily mean more (opportunistic) earnings/expectation manipulation –Are zero or small positive earnings surprises associated with lower future accounting performance? What is the involving picture? –Brown and Caylor (2005, TAR) show that after mid-1990s, managers put avoiding negative earnings surprise as first priority. –Before mid-1990s, avoiding quarterly earnings decrease is put at first priority. –Are the findings documented in this paper a part of a bigger picture? –Investigating pre-1992 data and quarterly earnings change may help? If the benefit of MBE declines, what will firms do? What is the picture in equilibrium?

6 Minor Issues Why use dummy transformation of control variables? –Transform into high/low dummy loses information Compared with , in , ERCs for all positive ES ranges are larger (table 4 and 6), but AERCs do not have such pattern. What does it imply? The results are little bit sensitive to scaling variable of ES. T-stats may need adjustment.

7 Conclusion An interesting and well-executed study. Enhance our understanding of MBE. May think more of the null hypothesis. More discussion of the links to the existing literature. Research design issues.