User:Well-rested/Earnings surprise

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Earnings surprise or unexpected earnings, in accounting, is the difference between the reported earnings and the expected earnings of an entity.^[1] Measures of a firm's expected earnings, in turn, include analysts' forecasts of the firm's profit^[2][3] and mathematical models of expected earnings based on the earnings of previous accounting periods.^[4][5]

Effect of earnings surprises

Stock markets tend to react in the same direction as the earnings surprise—positively to positive earnings surprises and negatively to negative earnings surprises—although a significant proportion of earnings surprises result in stock markets reacting in the opposite direction, which may be due to other relevant information released with the earnings announcement or inaccurate measurement of the earnings surprise.^[6]

The reaction to an earnings surprise, however, is an underreaction: accounting research has documented that the market takes several months to adjust to earnings surprises, particularly negative earnings surprises, a phenomenon known as the post-earnings announcement drift.^[7]

Large negative earnings surprises may have legal and reputational costs to managers. Firstly, managers can be held personally liable if shareholders sue the firm for failing to disclose negative earnings news promptly. Secondly, money managers may choose not to hold, and analysts may choose not to follow, the stocks of firms whose managers have reputations for withholding bad news. This may contribute to managers' voluntarily disclosure of negative earnings surprises: quarterly earnings announcements containing large negative earnings surprises are preempted by voluntary disclosures more frequently than are other earnings announcements.^[8]

Measurement

Earnings surprises can be measured using historical earnings or analysts' forecasts.^[9]

In accounting research, a measure that uses historical earnings is standardized unexpected earnings (SUE). SUE is the standardized difference between reported earnings and expected earnings, where expected earnings is modelled based on the assumption that earnings follows a seasonal random walk with a trend. In other words, in the case of quarterly earnings the SUE for quarter t is

${\displaystyle SUE_{t}={\frac {Q_{t}-E(Q_{t})}{\sigma (Q_{t}-E(Q_{t})}}}$

where σ(X) is the standard deviation of X, and the expected earnings, E(Q_t), is calculated using prior reported earnings:

${\displaystyle E(Q_{t})=\delta +Q_{t-4}}$

where Q_t-4 is the reported earnings for quarter t-4 and δ is the average trend.^[4]

An alternative measure of SUE that uses analysts' forecasts is

${\displaystyle SUE={\frac {EPS-Forecast}{\sigma (EPS-Forecast)}}}$

where EPS is a firm's earnings per share, and EPS Forecast is analysts' consensus forecast of its earnings per share.^[9]

References