Does Earnings Quality Affect Information Asymmetry: Evidence from Trading Costs

Information asymmetry in financial markets relates to the idea that one party to a transaction has better information than the other. Since financial reporting involves the transmission of value relevant enterprise information, we investigate whether the quality of reported earnings can contribute to differentially informed financial market participants. Higher information asymmetry is costly as it increases the adverse selection risk for market participants and lowers liquidity. For a large sample of NYSE and NASDAQ firms, we show that (i) poor earnings quality is significantly and incrementally associated with higher information asymmetry, (ii) earnings quality disproportionately affects information asymmetry for firms with poor information environments, (iii) both innate and discretionary components of earnings quality increase information asymmetry, and (iv) poor earnings quality exacerbates the information asymmetry around earnings announcements. Our results suggest that the standard setters’ efforts to develop accounting standards that improve earnings quality should contribute to a better information environment for market participants and increase stock liquidity

Assessing the relative informativeness and permanence of pro forma earnings and GAAP operating earnings

This study investigates whether market participants perceive pro forma earnings to be more informative and more persistent than standard GAAP operating income by analyzing a sample of 1,149 actual pro forma press releases issued between January 1998 and December 2000. We find that pro forma announcers report frequent GAAP losses and are mostly concentrated in the service and high-tech industries. We document a significant difference between pro forma numbers reported by managers and earnings figures published by I/B/E/S, and conclude that it is problematic to use an income figure reported by I/B/E/S as a proxy for pro forma earnings. Our analyses of short-window abnormal returns and revisions in analysts\u27 one-quarter-ahead earnings forecasts indicate that pro forma earnings are more informative and more permanent than GAAP operating earnings. Our evidence suggests that market participants believe pro forma earnings are more representative of core earnings than GAAP operating income

Investors’ Trade Size and Trading Responses Around Earnings Announcements: An Empirical Investigation.

Prior research suggests that the earnings expectations of a segment of the market can be described by the seasonal random-walk model. Prior research also provides evidence that less wealthy and less informed investors tend to make smaller trades (small traders) than wealthier and better informed investors (large traders). I hypothesize that it is the earnings expectations of small traders that are associated with predictions from the seasonal random-walk model. By directly analyzing the trading activities of small and large traders, this study provides evidence that is largely consistent with the hypotheses. Specifically, small traders\u27 trading response around earnings announcements is increasing in the magnitude of seasonal random-walk forecast errors even after controlling for absolute analyst forecast errors, contemporaneous price changes, and market-wide trading. Supplementary analysis reveals that this effect is largely confined to firms with relatively impoverished information environments (i.e., smaller firms and firms with little to moderate analyst following)